A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a
bank
A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
or other
financial institution
Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial inst ...
has to have as required by its
financial regulator. This is usually expressed as a
capital adequacy ratio Capital Adequacy Ratio (CAR) is 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 co ...
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
Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...
, 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.
Regulations
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
Deposit insurance or deposit protection is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due. Deposit insurance systems are one component of ...
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
The Basel Accords refer to the banking supervision accords (recommendations on banking regulations) issued by the Basel Committee on Banking Supervision (BCBS).
Basel I was developed through deliberations among central bankers from major countries ...
, published by the
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten (G10) countries in 1974. The committee expanded its membership in 2009 a ...
housed at the
Bank for International Settlements
The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks".
The BIS carries out its work th ...
. This sets a framework on how
bank
A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
s and
depository institution
Colloquially, a depository institution is a financial institution in the United States (such as a savings bank, commercial bank, savings and loan associations, or credit unions) that is legally allowed to accept monetary deposits from consumer
...
s must calculate their
capital
Capital may refer to:
Common uses
* Capital city, a municipality of primary status
** List of national capital cities
* Capital letter, an upper-case letter Economics and social sciences
* Capital (economics), the durable produced goods used fo ...
. 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
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 ...
. In June 2004 this framework was replaced by a significantly more complex capital adequacy framework commonly known as
Basel II
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.
The Basel II Accord was publi ...
. Following the
financial crisis of 2007–08
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
, Basel II was replaced by
Basel III
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 t ...
, which will be gradually phased in between 2013 and 2019.
Another term commonly used in the context of the frameworks is
economic capital
In finance, mainly for financial services firms, economic capital (ecap) is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market ...
, 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 t
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 Covenants- have been replaced by one single criterion. While the international standards of bank capital were established in the 1988
Basel I
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 ...
accord,
Basel II
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.
The Basel II Accord was publi ...
makes significant alterations to the interpretation, if not the calculation, of the capital requirement.
Examples of national regulators implementing
Basel
, french: link=no, Bâlois(e), it, Basilese
, neighboring_municipalities= Allschwil (BL), Hégenheim (FR-68), Binningen (BL), Birsfelden (BL), Bottmingen (BL), Huningue (FR-68), Münchenstein (BL), Muttenz (BL), Reinach (BL), Riehen (B ...
include the
FSA in the UK,
BaFin
The Federal Financial Supervisory Authority (german: Bundesanstalt für Finanzdienstleistungsaufsicht, Bundesanstalt für Finanzdienstleistungsaufsicht) better known by its abbreviation BaFin is the financial regulatory authority for Germany. It ...
in Germany,
OSFI
The Office of the Superintendent of Financial Institutions (OSFI; french: Bureau du surintendant des institutions financières, BSIF) is an independent agency of the Government of Canada reporting to the Minister of Finance created "to contribute ...
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.
In the European Union member states have enacted capital requirements based on the
Capital Adequacy Directive
The Capital Adequacy Directive was a European directive that aimed to establish uniform capital requirements for both banking firms and non-bank securities firms, first issued in 1993 and revised in 1998. These was superseded by the Capital Requ ...
CAD1 issued in 1993 and CAD2 issued in 1998.
In the United States,
depository institutions
Colloquially, a depository institution is a financial institution in the United States (such as a savings bank, commercial bank, savings and loan associations, or credit unions) that is legally allowed to accept monetary deposits from consumers. ...
are subject to risk-based capital guidelines issued by the
Board of Governors of the Federal Reserve System
The Board of Governors of the Federal Reserve System, commonly known as the Federal Reserve Board, is the main governing body of the Federal Reserve System. It is charged with overseeing the Federal Reserve Banks and with helping implement the mo ...
(FRB). These guidelines are used to evaluate capital adequacy based primarily on the perceived
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
associated with
balance sheet assets, as well as certain
off-balance sheet
Off balance sheet (OBS), or incognito leverage, usually means an asset or debt or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item.
Some companies may have significant amounts o ...
exposures such as
unfunded loan commitments {{unreferenced, date=February 2014
Unfunded loan commitments are those commitments made by a Financial institution that are contractual obligations for future funding. They should not be confused with Letters of credit which require certain trigger ...
,
letters of credit
A letter of credit (LC), also known as a documentary credit or bankers commercial credit, or letter of undertaking (LoU), is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exp ...
, and
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...
s and
foreign exchange contracts. The risk-based capital guidelines are supplemented by a
leverage ratio
In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever i ...
requirement. To be ''adequately capitalized'' under federal bank regulatory agency definitions, a
bank holding company
A bank holding company is a company that controls one or more banks, but does not necessarily engage in banking itself. The compound bancorp (''banc''/''bank'' + '' corp ration') is often used to refer to these companies as well.
United States ...
must have a
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.By definition of Bank for International Settlements. It is composed of ''core capital'', which consists primarily of common stock and disclosed res ...
ratio of at least 4%, a combined Tier 1 and
Tier 2 capital Tier 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement.By definition of Bank for International Settlements. These forms of banking capital were largely standardized in t ...
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
A bank holding company is a company that controls one or more banks, but does not necessarily engage in banking itself. The compound bancorp (''banc''/''bank'' + '' corp ration') is often used to refer to these companies as well.
United States ...
must have a
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.By definition of Bank for International Settlements. It is composed of ''core capital'', which consists primarily of common stock and disclosed res ...
ratio of at least 6%, a combined Tier 1 and
Tier 2 capital Tier 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement.By definition of Bank for International Settlements. These forms of banking capital were largely standardized in t ...
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
All regulated financial institutions in the United States are required to file periodic financial and other information with their respective regulators and other parties. Thrifts are required by the Office of Thrift Supervision (OTS), among othe ...
. Although Tier 1 capital has traditionally been emphasized, in the
Late-2000s recession regulators and investors began to focus on
tangible common equity Tangible common equity (TCE), the subset of shareholders' equity that is not preferred equity and not intangible assets, is an uncommonly used measure of a company's financial strength. It indicates how much ownership equity owners of common stock ...
, which is different from Tier 1 capital in that it excludes
preferred equity
Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt ins ...
.
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.
Regulatory capital
In the
Basel II
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.
The Basel II Accord was publi ...
accord bank capital has been divided into two "tiers"
, each with some subdivisions.
Tier 1 capital
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.By definition of Bank for International Settlements. It is composed of ''core capital'', which consists primarily of common stock and disclosed res ...
, 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
A hire purchase (HP), also known as an installment plan, is an arrangement whereby a customer agrees to a contract to acquire an asset by paying an initial installment (e.g., 40% of the total) and repaying the balance of the price of the asset pl ...
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
A non-banking financial institution (NBFI) or non-bank financial company (NBFC) is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency. NBFC facilitate ba ...
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
International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's fina ...
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
Boyd, Tony, "A Capital Idea", 21 October 2008
/ref> that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority
The Australian Prudential Regulation Authority (APRA) is a statutory authority of the Australian Government and the prudential regulator of the Australian financial services industry. APRA was established on 1 July 1998 in response to the re ...
, 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 ≥ 3%
See also
*Basel II
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.
The Basel II Accord was publi ...
*Basel III
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 t ...
*Reserve requirement
Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...
*Capital adequacy ratio Capital Adequacy Ratio (CAR) is 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 co ...
* KVA, the x-Valuation Adjustment for regulatory capital
References
External links
The Basel I Accord
FDIC Call and TFR Data
{{Authority control
Insurance