Managing differences in economic and regulatory capital: An examination of return of equity (ROE) maximising strategies

Abstract

As per their internal capital adequacy assessment process (ICAAP) and own risk and solvency assessment (ORSA) frameworks, financial institutions (FIs) are subject to both regulatory capital (RC) and economic capital (EC) requirements, the maximum of which becomes the binding constraint, determining the minimum amount of available capital the FI needs to hold. This paper examines alternative strategies and dynamics of the relative RC and EC relationship as FIs seek to maximise return on equity (ROE). The paper shows that EC remains relevant even in cases where RC requirements are higher on aggregate. Under such circumstances FIs are incentivised to ‘dial up’ economic risk by expanding businesses that consume more EC than RC or by divesting businesses consuming more RC than EC in order to enhance ROE. It is explicitly shown that dialling up economic risk lifts up return on EC, boosting ROE. As these opportunities are arbitraged away, EC and RC requirements will tend to converge over time. These strategies, while improving ROE, come at an economic cost. While improving ROE in the short run, low return on EC business may need to be acquired or high return on EC business may need to be divested. The higher the RC relative to EC on aggregate, the higher the potential economic cost. Both the FIs and regulators should prefer EC being the binding constraint on aggregate, supported by strong ICAAP and ORSA frameworks.