Regulatory Capital: Why is it Different?

Abstract

The global financial crisis has highlighted that deviations between the accounting and regulatory concepts of equity capital have gone too far. Accounting standards have been going too far in the application of fair value accounting. If there are no markets during times of crises, it does not make sense to mark-to-market. These exceptions have now been included in the accounting standards. At the same time, regulatory capital has gone astray by allowing debt elements, such as subordinated debt, to be incorporated, which did not absorb losses during the crisis. The new Basel III capital framework is rightfully reinforcing the central role of equity capital.While the special liquidity function of banks may justify lower levels of capital than those of industrial firms, the social cost of bank failures (externalities) requires higher levels than the extremely low levels of bank capital before the crisis. The level of regulatory capital has been increased, with a systemic surcharge for the large banks, to reduce the too-big-to-fail (TBTF) subsidy for these banks.