What is the difference between regulatory capital and economic capital?

• A. Regulatory capital is the minimum required by regulators; economic capital is an internal estimate of capital needed for risk exposure.
• B. Regulatory capital is an internal estimate; economic capital is the minimum required by regulators.
• C. Regulatory capital equals profits; economic capital equals cash.
• D. Regulatory capital and economic capital are the same.

Answer: (A)

Regulatory capital is the amount a bank must hold to meet supervisors’ requirements. It’s a floor set by frameworks such as Basel III, designed to ensure the bank can absorb losses and stay solvent under stress. Economic capital, on the other hand, is the bank’s own assessment of how much capital is needed to cover its risk exposures given its risk appetite and models. It’s an internal target, not a regulatory mandate, and it can be higher or lower than the regulatory minimum depending on how much risk the bank is willing to take and how its risk estimates look.

So the best choice captures that regulatory capital is the minimum required by regulators, while economic capital is an internal estimate of the capital needed to cover risk exposure. The other ideas mix up which is mandatory, or equate capital with profits or cash, which isn’t accurate.