Working Paper: CEPR ID: DP4770
Authors: Abel Elizalde; Rafael Repullo
Abstract: This Paper analyses the determinants of regulatory capital (the minimum required by regulation) and economic capital (the capital that shareholders would choose in absence of regulation) in the context of the single risk factor model that underlies the New Basel Capital Accord (Basel II). The results show that economic and regulatory capital do not depend on the same set of variables and do not react in the same way to changes in their common determinants. For plausible parameter values, they are both increasing in the loans? probability of default and loss given default, but variables that affect economic but not regulatory capital, such as the intermediation margin and the cost of capital, can move them significantly apart. The results also show that market discipline, proxied by the coverage of deposit insurance, increases economic capital, although the effect is generally small.
Keywords: Bank Regulation; Basel II; Capital Requirements; Credit Risk; Market Discipline
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Loans' probability of default (G33) | Economic capital (E22) |
| Loans' probability of default (G33) | Regulatory capital (G28) |
| Loss given default (G33) | Economic capital (E22) |
| Loss given default (G33) | Regulatory capital (G28) |
| Intermediation margin (G19) | Economic capital (E22) |
| Cost of capital (G31) | Economic capital (E22) |
| Confidence level set by regulator (G18) | Regulatory capital (G28) |
| Market discipline (proxied by deposit insurance coverage) (G28) | Economic capital (E22) |
| Cost of bank capital (G21) | Relative position of economic capital compared to regulatory capital (G18) |