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If economic capital is set by the institution to cover unexpected loss (given a confidence level) and regulatory capital is set by the regulator, can one "absorb" the other?

For example, if I determine I want my fictional bank to hold 5bn in economic capital as that corresponds to 99.98% confidence of my loss distribution and the local regulator says I need to hold a total of 3bn in regulatory capital based on my regulatory filings, can I say I'm holding 5 already for EC so I'm covered? Or do I have to hold 5 + 3?

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Depending on the bank and the country the bank operates in, regulators don't care about your bank's EC so you wouldn't have to hold 5+3; just 3 (or, if you are prudent/conservative, 5). In the US the regulatory capital requirements tend to be fairly conservative and I would think most banks have EC that is well below regulatory capital.

Under the Basel advanced approaches banks can substitute internal estimates of capital for regulatory capital, though I believe that the equity ratio has a hard floor of 5% and that frequently a 2% "buffer" is required above this.

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  • $\begingroup$ From your answer, I take it that regulatory capital generally csnnot be reduced byban amount of economic capital either? Eg EC =2 reg cap =5 and 5-3? $\endgroup$ – AfterWorkGuinness Oct 9 '15 at 12:25
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Economic Capital (EC) covers potential losses under normal conditions, whereas Regulatory Capital (RC) covers potential losses under stressed conditions. Thus, is not uncommon for the RC to be grater than the EC.

If $T1$ is the bank's Tier 1 capital and $T1^*$ is the related minimum capital, we have

$T1 = T1^* + EC$.

I suggest reading Chapter 22 of Resti & Sironi - Risk management and shareholder's value in banking.

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