In Focus Risk


Capital requirements – regulatory or economic?


The differing purposes and importance of capital requirements is important to understand when making an assessment


Rajib Chakravorty Independent consultant, HSBC rajib32@hotmail.com


Capital is important because it is one way for companies to prevent themselves from being liquidated or made bankrupt, as it provides a buffer against insolvency. It provides a good defence against bad days. Without adequate capital, a company can


be bankrupt, or at the brink of collapse, as demonstrated by large financial institutions, such as Lehman Brothers, during the global financial crisis in 2008. Hence, having adequate capital is important to prevent a company from bankruptcy.


Basel II set up capital-management requirements to ensure that a bank has adequate capital for the risks it is exposed to through its lending and investment practices


Key areas of regulatory pressure by different region


Basel II Capital requirement is the determination of how much capital is needed to sustain operating losses while meeting any liabilities demand. For instance, in order to guide the determination of capital amount, the Basel Committee on Banking Supervision issued Basel II which includes recommendations on banking laws and regulations. Basel II set up capital-management


Source: World Bank Annual KPMG Workshop – Bank Regulatory Update


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requirements to ensure that a bank has adequate capital for the risks it is exposed to through its lending and investment practices. In general, the higher the risk level, the greater the amount of capital required, and this is the principle of risk- based capital management.


www.CCRMagazine.co.uk To compare economic and regulatory


capital, one must first clarify the meaning of each term. The definition of regulatory capital is


clear: it is the minimum capital required by the regulator, which is identified with the capital charges in the Basel II. Economic capital is usually defined as the


capital level that is required to cover the bank’s losses with a certain probability or confidence level.


Economic capital Economic capital can also be defined as the methods or practices that allow banks to consistently assess risk and attribute capital to cover the economic effects of their risk- taking activities. Economic capital can be analysed and used


at various levels – ranging from firm-wide aggregation, to risk-type or business-line level, and down further still to the individual portfolio or exposure level. Many building blocks of economic capital


are, therefore, complex and raise challenges for banks and supervisors. Banks use required economic capital for


many purposes, including: l Capital adequacy assessment. l External reporting. l Strategic planning. l Capital budgeting. l Risk and performance measurement. l Limit setting. l Risk-based pricing. l Customer-profitability analysis.


April 2017


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