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Capital requirement

From Wikipedia, the free encyclopedia

A capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds not a use of funds.

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  • ✪ The Fed Explains Bank Supervision and Regulation
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There are all kinds of businesses in our economy. They all have one thing in common: They want to earn money so they can run their operations, provide service for their customers, and get a reasonable return for their owners. A bank is no different. So, how does a bank earn money? It lends money to members of the community who can pay back what they borrow. These borrowers are charged interest. This is the main way banks make money and stay healthy. The Fed wants to keep the economy growing so that's why they want to make sure all banks stay healthy. The healthier the bank, the healthier the economy and the communities that it serves. The way the Fed supervises and regulates banks keeps evolving. Since the financial crisis of 2008, the Fed, along with other bank supervisors, conducts stress tests on the nation's largest financial institutions making sure they have the capital they need to stay healthy in case of an economic downturn. These days the Fed and other regulators are looking at risk across multiple banks, not just at individual institutions, watching out for the stability of the entire financial system. This broader review model is called macro-prudential regulation, and it makes the financial system more resilient to systemic shocks. That's why the Fed, along with other federal and state authorities, keeps an eye on banks. These agencies make sure banks do business safely and provide fair and equitable services to their communities. How? First, the Fed makes sure all deposits are safe by requiring all banks to keep a percentage of deposits in reserve as cash in their vaults or in accounts at a federal reserve bank. Then, to make sure banks stay safe and sound, the Fed sends out examiners to inspect banks, both big and small. They check on how well a bank is run by asking basic questions. For example, Does a bank make good investments? Does it take care of people's money? Does it follow safe banking rules? The Fed gets all this information from the banks in the form of Bank Call Reports. Fed examiners review these reports first off site, and then go on site to inspect bank records and facilities. Then the Fed examiners combine all this information to measure the health of the bank. Once the information is collected, the examiners study the bank's condition by applying the Camels Rating. Each letter stands for one of the 6 components of a bank's health. Capital adequacy: Do they have enough capital to do business? Capital acts like a cushion to absorb losses that could otherwise cause a bank to fail. Asset quality: Are their loans and other investments safe and sound? Management: Do their managers know what they're doing? Earnings: Are they making a profit? Liquidity: Do they have enough funds on hand to pay back their depositors? And Sensitivity to market risk: Do they make wise decisions based on their understanding of risk? This Camels Rating gives banks a confidential assessment from 1 to 5, with 1 being the top rating and 5 being the lowest. What happens if a bank gets a poor rating? The Fed goes back, does more examinations and offers guidance to the bank in question. Sometimes the Fed and the bank have written agreements on how to rectify the situation. If banks continue to perform badly, they can become insolvent and be shut down, but the depositors are protected. The FDIC ensures depositors' money from loss up to $250,000. Another part of ensuring that banks are serving their communities? Making sure banks are lending fairly. That's where the Fed's Consumer Compliance comes in. They make sure loan applications are judged on the consumer's ability to repay the loan, not on their race, religion or neighborhood. The Fed also makes sure banks are complying with consumer protection laws by disclosing the correct interest rate on loans. This is to make sure customers don't get charged any hidden fees when they borrow money. The Fed is committed to safe and sound banking, so if consumers have a complaint about a financial institution, they can contact the Federal Reserve. The Fed will look into banking practices and investigate those complaints keeping our banking system safe and sound and the economy and all communities growing. For more information, visit the Atlanta Fed online at



A key part of bank regulation is to make sure that firms operating in the industry are prudently managed. The aim is to protect the firms themselves, their customers, the government (which is liable for the cost of deposit insurance in the event of a bank failure) and the economy, by establishing rules to make sure that these institutions hold enough capital to ensure continuation of a safe and efficient market and are able to withstand any foreseeable problems.

The main international effort to establish rules around capital requirements has been the Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements. This sets a framework on how banks and depository institutions must calculate their capital. After obtaining the capital ratios, the bank capital adequacy can be assessed and regulated. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I. In June 2004 this framework was replaced by a significantly more complex capital adequacy framework commonly known as Basel II. Following the financial crisis of 2007–08, Basel II was replaced by Basel III,[1] which will be gradually phased in between 2013 and 2019.[2]

Another term commonly used in the context of the frameworks is economic capital, which can be thought of as the capital level bank shareholders would choose in the absence of capital regulation. For a detailed study on the differences between these two definitions of capital, refer to Economic and Regulatory Capital in Banking: What is the Difference.

The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Basel II requires that the total capital ratio must be no lower than 8%.

Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework.

Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a bank's capital eroded by the yearly inflation rate.

The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital- have been replaced by one single criterion. While the international standards of bank capital were established in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.

Examples of national regulators implementing Basel include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy. In the United States the primary regulators implementing Basel include the Office of the Comptroller of the Currency and the Federal Reserve.[3]

In the European Union member states have enacted capital requirements based on the Capital Adequacy Directive CAD1 issued in 1993 and CAD2 issued in 1998.

In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB).[4] These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. Although Tier 1 capital has traditionally been emphasized, in the Late-2000s recession regulators and investors began to focus on tangible common equity, which is different from Tier 1 capital in that it excludes preferred equity.[5]

Regulatory capital requirements typically (although not always) are imposed at both an individual bank entity level and at a group (or sub-group) level. This may therefore mean that several different regulatory capital regimes apply throughout a bank group at different levels, each under the supervision of a different regulator.[6]

Regulatory capital

In the Basel II accord bank capital has been divided into two "tiers" [7] , each with some subdivisions.

Tier 1 capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity and disclosed reserves. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $20 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $300. Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities.

In India, the Tier 1 capital is defined as "'Tier I Capital' means "owned fund" as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a systemically important non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;" (as per Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007) In the context of NBFCs in India, the Tier I capital is nothing but net owned funds.

Owned funds stand for paid up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any.

Tier 2 (supplementary) capital

Tier 2 capital, supplementary capital, comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Undisclosed reserves

Undisclosed reserves are where a bank has made a profit but this has not appeared in normal retained profits or in general reserves.

Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

General provisions

A general provision is created when a company is aware that a loss has occurred, but is not certain of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.

Hybrid debt capital instruments

They consist of instruments which combine certain characteristics of equity as well as debt. They can be included in supplementary capital if they are able to support losses on an ongoing basis without triggering liquidation.

Sometimes, it includes instruments which are initially issued with interest obligation (e.g. debentures) but the same can later be converted into capital.

Subordinated-term debt

Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10 years and ranks senior to Tier 1 capital, but subordinate to senior debt in terms of claims on liquidation proceeds. To ensure that the amount of capital outstanding doesn't fall sharply once a Lower Tier 2 issue matures and, for example, not be replaced, the regulator demands that the amount that is qualifiable as Tier 2 capital amortises (i.e. reduces) on a straight line basis from maturity minus 5 years (e.g. a 1bn issue would only count as worth 800m in calculating capital 4 years before maturity). The remainder qualifies as senior issuance. For this reason many Lower Tier 2 instruments were issued as 10 year non-call 5 year issues (i.e. final maturity after 10 years but callable after 5 years). If not called, issue has a large step - similar to Tier 1 - thereby making the call more likely.

Different international implementations

Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction.

For example, it has been reported[8] that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Prudential Regulation Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.

European Union

In the EU countries the capital requirements as set out by Basel III agreement have been implemented by the so-called CRD IV package which commonly refers to both the EU Directive 2013/36/EU and the EU Regulation 575/2013.

Common capital ratios

  • CET1 Capital Ratio = Common Equity Tier 1 / Credit risk-adjusted asset Value ≥ 4.5%
  • Tier 1 capital ratio = Tier 1 capital / Credit risk-adjusted assets value ≥ 6%
  • Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 + Tier 2) / Credit risk-adjusted assets ≥ 8%
  • Leverage Ratio = Tier 1 capital / Average total consolidated assets value ≥ 4%

See also


  1. ^ Page 27, Basel III:A global regulatory framework for more resilient banks and banking systems
  2. ^ Basel III phase-in arrangements
  3. ^ "Basel leverage ratio: No cover for US banks" (PDF). PwC Financial Services Regulatory Practice, January, 2014.
  4. ^ FDIC:Capital measures and capital category definition
  5. ^ Stress Test for Banks Exposes Rift on Wall St.. NYTimes.
  6. ^ Morris, CHR (2019). The Law of Financial Services Groups. Oxford University Press. pp. 78–249. ISBN 978-0-19-884465-5.
  7. ^ "International Convergence of Capital Measurement and Capital Standards:A Revised Framework:Comprehensive Version" (PDF). Pg 14: Basel Committee on Banking Supervision. 2006.
  8. ^ Boyd, Tony, "A Capital Idea", 21 October 2008

External links

This page was last edited on 9 October 2019, at 13:53
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