Value at Risk and Bank Capital Management

approaches, especially during the transition phase, for U.S.-based and non-U.S.-based

international banks.

2.3 Bank Estimates of Required Capital and the Different

Notions of Bank Capital

While a bank always has to comply with the constraint of maintaining a suffi cient level

of regulatory capital, minimum regulatory capital requirements may not coincide per-

fectly with the internal estimate of the capital needed to run the business, which is usually

identifi ed as economic capital. Economic capital can differ from regulatory capital for a

number of reasons, such as a different treatment of diversifi cation benefi ts among different

businesses and risks and the inclusion of economic capital estimates for risks that have

no formal measurement (e.g., business or strategic risks). At the same time, not only may

required capital be different if we adopt a regulatory or an economic perspective, but

available capital will differ too. In fact, regulatory capital also comprises components,

such as subordinated and hybrid debt, that do not represent a portion of capital in a strict

sense. Hence, most banks compare both (i) regulatory requirements with regulatory

capital and (ii) internally estimated required economic capital with available economic

capital. Economic capital, rather than regulatory capital, is also mainly used for risk-

adjusted performance measurement, even if return on regulatory capital may also be

reported to top managers as supplementary information.

When defi ning an internal estimate of economic capital, that is, when trying to

measure how much capital the bank should hold to face potential losses over a given time

horizon, there are different concepts of bank capital that can be adopted.

The fi rst one is book value of capital, which can be defi ned as the difference between

the book value of the bank’s assets and that of its liabilities. The second one is market

value of capital, i.e., the difference between the value of assets and the value of liabilities

when both are valued at mark-to-market prices (Saunders 1994). The third one is market

capitalization, i.e., the value of the bank on the stock market at current market prices.

Market capitalization should refl ect the complex evaluation the market may make about

the market value of the bank’s assets and liabilities, the bank’s business mix and the per-

spective of each business the bank is in, its competitive position, and a number of other

factors. Since there are different concepts of bank capital, the bank could, at least poten-

tially, measure required capital according to each of these different views. Yet book capital

on the one hand and market capitalization on the other are usually the two key measures

with which a CEO is concerned. We concentrate mostly on these two.

2.3.1 Book Value of Capital and the Impact of IAS/IFRS

When a bank has to check whether, according to its own measurement methodologies, its

capital is adequate to face potential losses, one usual measure of available capital is the

book value of capital. In fact, a bank would clearly default if all book value of capital

were destroyed. If this view were adopted, then risks should be measured according

to the amount of book capital that could be lost due to adverse events or market

movements.

The idea that a bank might calculate economic capital (which we defi ned as the bank’s

internal estimate of the capital needed to run the business) in terms of book value may

BANK ESTIMATES OF REQUIRED CAPITAL 17