A capital requirement (also known as regulatory capital, capital adequacy or capital base) 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 risk becoming 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.
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.[3]
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 five Cs of Credit—Character, Cash Flow, Collateral, Conditions and Covenants—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.[4]
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).[5] 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 financial 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.[6]
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.[7]
Regulatory capital
In the Basel II accord bank capital has been divided into two "tiers",[8] each with some subdivisions.
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 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 does not 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[9] 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 / Risk-weighted assets ≥ 4.5%
The Basel Accords refer to the banking supervision accords issued by the Basel Committee on Banking Supervision (BCBS).
Banking regulation and supervision refers to a form of financial regulation which subjects banks to certain requirements, restrictions and guidelines, enforced by a financial regulatory authority generally referred to as banking supervisor, with semantic variations across jurisdictions. By and large, banking regulation and supervision aims at ensuring that banks are safe and sound and at fostering market transparency between banks and the individuals and corporations with whom they conduct business.
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III.
In finance, leverage, also known as gearing, is any technique involving borrowing funds to buy an investment.
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be phased out during the implementation of Basel III.
Tier 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement. These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation. In the calculation of regulatory capital, Tier 2 is limited to 100% of Tier 1 capital.
Basel I is the first Basel Accord. It arose from deliberations by central bankers from major countries during the late 1970s and 1980s. In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. It is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992.
Capital Adequacy Ratio (CAR) also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements.
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
Valuation risk is the risk that an entity suffers a loss when trading an asset or a liability due to a difference between the accounting value and the price effectively obtained in the trade.
The uniform net capital rule is a rule created by the U.S. Securities and Exchange Commission ("SEC") in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors. Broker-dealers are companies that trade securities for customers and for their own accounts.
Risk-weighted asset is a bank's assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. In the Basel I accord published by the Basel Committee on Banking Supervision, the Committee explains why using a risk-weight approach is the preferred methodology which banks should adopt for capital calculation:
Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. After the 2007–2008 financial crisis, there has been a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.
Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing minimum capital requirements, holdings of high quality liquid assets, and decreasing bank leverage.
During the financial crisis of 2007–2008, several banks, including the UK's Northern Rock and the U.S. investment banks Bear Stearns and Lehman Brothers, suffered a liquidity crisis, due to their over-reliance on short-term wholesale funding from the interbank lending market. As a result, the G20 launched an overhaul of banking regulation known as Basel III. In addition to changes in capital requirements, Basel III also contains two entirely new liquidity requirements: the net stable funding ratio (NSFR) and the liquidity coverage ratio (LCR).
A systemically important financial institution (SIFI) is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis. They are colloquially referred to as "too big to fail".
Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.
A contingent convertible bond (CoCo), also known as an enhanced capital note (ECN), is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs. The concept of CoCo has been particularly discussed in the context of crisis management in the banking industry. It has been also emerging as an alternative way for keeping solvency in the insurance industry.
Basel III: Finalising post-crisis reforms, sometimes called the Basel III Endgame, Basel 3.1 or CRR3, are changes to international standards for bank capital requirements that were agreed by the Basel Committee on Banking Supervision (BCBS) in 2017 and are due for implementation in January 2023. They amend the international banking standards known as the Basel Accords.
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