This document discusses integrating regulatory and economic capital approaches. Regulatory capital is important for maintaining solvency but does not assess tail risk, while economic capital can measure tail risk but is not mandatory. The document proposes that integrating the two approaches by incorporating regulatory capital ratios into an economic capital operating model could address this paradigm, using economic capital flexibly while still meeting regulatory capital adequacy requirements. It suggests extending economic capital management to "going concern" normal stress conditions in addition to "gone concern" extreme stress conditions to optimize capital management cohesively.

1. Integrating Regulatory and
Economic Capital
A Strategic Approach
Nikat Malik
July 2016
All Rights Reserved

2. The financial crisis of recent times has brought the role of capital management into the limelight. As
financial institutions and regulators alike attempt to secure solvency and sustain viability with capital –
using it to protect against losses as well as promote growth. Financial institutions are undertaking a
more active and comprehensive approach to capital management, establishing it as the very foundation
of business strategy to construct the balance sheet, define capitalization levels, internal management
structures, operational legal entities and risk management.
Due to its very nature, extensive reliance has been placed on regulatory capital to maintain solvency and
business continuity at defined operational levels. Though regulatory capital was deemed sufficient
during the financial crisis, it was not enough to prevent the crisis, which continues and has significantly
altered the playing field. A `new normal` operating environment in financial sector profitability has
occurred compounded with low and negative interest rates which have impacted `net interest income`
adversely. The ability to generate internal capital and retain earnings remain key to viability.
So far, regulatory capital has been an integral part of business steering approach and operates as the
binding constraint. It is now actively applied in pricing decisions and allocated more dynamically than
before.
Loss management remains a major issue in managing profitability and consequent solvency. Tail risk is a
key threat in current prevalent turbulent times and structural change. Fat and long tails are sharp events
which can dent the resilience of any institution. The unique feature of economic risk capital
measurement method is its ability to assess and manage tail risk. Further, economic capital based on
economic values provides a much truer picture of the economic risks facing an enterprise, hence merits
due consideration.
Regulatory capital, though a mandatory requirement is not complete enough to manage enterprise risk
across the loss distribution life cycle primarily due to its inability to assess tail risk. Economic capital can
however be configured to manage risk across the entire life cycle but is not a mandatory requirement.
To address this paradigm, an integration of the two is necessary. Regulatory capital is insensitive to
business risk management as it is applied as per regulatory guidance across institutions and does not
distinguish between the structure of different institutions with different businesses and strategies. It is
suitable to satisfy mandatory regulatory demands but inadequate to drive business objectives and
strategies. Regulatory capital currently used in pricing decisions is aimed primarily to cover aggregate
capital demands driven by capital adequacy requirements. Economic capital provides flexibility and
enables competitive pricing. A possible way is to incorporate regulatory capital ratios into economic
capital operating model and use it to meet capital adequacy requirements.

3. The role of regulatory capital and economic capital depend largely on portfolio risks and balance sheet
structure of an enterprise. The composition of portfolio and enterprise risks as defined by the risk
management framework are key to defining the role of economic and regulatory capital, as also is the
risk measurement method.
Going and gone concern capital management, a relatively new dimension, supports the definition of the
role of economic and regulatory capital. It is important to recognize that `going concern` operates in
normal stress conditions; while `gone concern` operates in extreme stress conditions.
To enable cohesive capital management and optimize its use, it will be prudent to extend economic
capital management to going concern. This is evidenced by recent regulatory developments which
emphasize capital management under both going and gone concern operating conditions.
Strategic Options: