Regulatory versus Economic Capital: How Do Large Banks Manage their Capital Ratios?

Capital regulation requires banks to hold a prescribed amount of equity relative to their risk-weighted assets. Beyond these minimum requirements, banks usually hold additional capital. In this paper, we argue that a part of this capital buffer represents banks' response to regulatory risk weights, which may not adequately measure the actual risks of banks' asset portfolios. Using a sample of large European banks, we show that bank capital not only increases with regulatory requirements, but also with increasing asset risk. Further, banks with below-average risk weights relative to their actual economic risk hold more capital as buffer. We conclude that banks pursue an economic capital management based on the market's capital "requirements".