Capital requirement

Capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held 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.

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 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 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.^[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 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 laid down 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 Officer 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 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

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

Tier 1 capital

Main article: 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 $10 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 $200. 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

Main article: Tier 2 capital

Tier 2 capital, or 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 debt, but subordinate to senior debt. 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 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 Financial Services 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 ≥ 5%

References

↑ Page 27, Basel III:A global regulatory framework for more resilient banks and banking systems
↑ Basel III phase-in arrangements
↑ Economic and Regulatory Capital in Banking: What is the Difference
↑ "Basel leverage ratio: No cover for US banks" (PDF). http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-basel-leverage-ratio.jhtml. PwC Financial Services Regulatory Practice, January, 2014. External link in |website= (help)
↑ FDIC:Capital measures and capital category definition
↑ Stress Test for Banks Exposes Rift on Wall St.. NYTimes.
↑ "International Convergence of Capital Measurement and Capital Standards:A Revised Framework:Comprehensive Version" (PDF). Pg 14: Basel Committee on Banking Supervision. 2006.
↑ Boyd, Tony, "A Capital Idea", 21 October 2008

External links

Central banks

Global

Global	Bank for International Settlements Basel Committee on Banking Supervision Financial Stability Board

By continent

Africa	Bank of Central African States Central Bank of West African States Bank of Algeria National Bank of Angola Bank of Botswana Bank of the Republic of Burundi Bank of Cape Verde Central Bank of the Comoros Central Bank of the Congo Central Bank of Djibouti Central Bank of Egypt Bank of Eritrea National Bank of Ethiopia Central Bank of The Gambia Bank of Ghana Central Bank of the Republic of Guinea Central Bank of Kenya Central Bank of Lesotho Central Bank of Liberia Central Bank of Libya Central Bank of Madagascar Reserve Bank of Malawi Central Bank of Mauritania Bank of Mauritius Bank Al-Maghrib (Morocco) Bank of Mozambique Bank of Namibia Central Bank of Nigeria National Bank of Rwanda Central Bank of São Tomé and Príncipe Central Bank of Seychelles Bank of Sierra Leone Central Bank of Somalia Bank of Somaliland South African Reserve Bank Bank of South Sudan Central Bank of Sudan Central Bank of Swaziland Bank of Tanzania Central Bank of Tunisia Bank of Uganda Bank of Zambia Reserve Bank of Zimbabwe

Americas	Central Bank of Argentina Central Bank of Aruba Central Bank of The Bahamas Central Bank of Barbados Bermuda Monetary Authority Central Bank of Brazil Bank of Canada Central Bank of Chile Bank of the Republic (Colombia) Central Bank of Cuba Central Bank of Curaçao and Sint Maarten Eastern Caribbean Central Bank Cayman Islands Monetary Authority Central Bank of Ecuador Bank of Guatemala Bank of the Republic of Haiti Central Bank of Honduras Bank of Jamaica Bank of Mexico Central Bank of Nicaragua Central Reserve Bank of Peru Central Bank of Suriname Central Bank of Trinidad and Tobago Federal Reserve System (United States) Central Bank of Uruguay Central Bank of Venezuela

Asia	Da Afghanistan Bank Central Bank of Bahrain Bangladesh Bank Royal Monetary Authority of Bhutan Brunei Currency and Monetary Board Autoriti Monetari Brunei Darussalam National Bank of Cambodia People's Bank of China Hong Kong Monetary Authority Reserve Bank of India Bank Indonesia Central Bank of the Islamic Republic of Iran Central Bank of Iraq Bank of Israel Bank of Japan Central Bank of Jordan National Bank of Kazakhstan National Bank of the Kyrgyz Republic Bank of Korea Central Bank of the Democratic People's Republic of Korea Central Bank of Kuwait Banque du Liban Monetary Authority of Macao Bank Negara Malaysia Maldives Monetary Authority Bank of Mongolia Central Bank of Myanmar Nepal Rastra Bank Central Bank of Oman State Bank of Pakistan Palestine Monetary Authority Bangko Sentral ng Pilipinas Qatar Central Bank Saudi Arabian Monetary Agency Monetary Authority of Singapore Central Bank of Sri Lanka Central Bank of Syria Central Bank of the Republic of China (Taiwan) Bank of Thailand Central Bank of Turkmenistan Central Bank of the United Arab Emirates Central Bank of Uzbekistan State Bank of Vietnam Central Bank of Yemen

Europe	European Central Bank (Eurosystem) National Bank of the Republic of Abkhazia Bank of Albania Central Bank of Armenia National Bank of Austria Central Bank of Azerbaijan National Bank of the Republic of Belarus National Bank of Belgium Central Bank of Bosnia and Herzegovina Bulgarian National Bank Croatian National Bank Central Bank of Cyprus Czech National Bank Danmarks Nationalbank (Denmark) Deutsche Bundesbank (Germany) Bank of England Bank of Estonia Bank of Finland Banque de France National Bank of Georgia Bank of Greece Hungarian National Bank Central Bank of Iceland Central Bank of Ireland Banca d'Italia Central Bank of Kosovo Bank of Latvia Bank of Lithuania Central Bank of Luxembourg National Bank of the Republic of Macedonia Central Bank of Malta National Bank of Moldova Central Bank of Montenegro De Nederlandsche Bank Norges Bank Central Bank of the Turkish Republic of Northern Cyprus National Bank of Poland Banco de Portugal National Bank of Romania Central Bank of Russia National Bank of Serbia National Bank of Slovakia Bank of Slovenia Gosbank (Soviet Union) Bank of Spain Swedish National Bank Swiss National Bank Central Bank of the Republic of Turkey National Bank of Ukraine

Oceania	Reserve Bank of Australia Reserve Bank of Fiji Reserve Bank of New Zealand Bank of Papua New Guinea Central Bank of Samoa Central Bank of Solomon Islands National Reserve Bank of Tonga

Policies and implementation

Policies	Capital requirement Contractionary monetary policy Expansionary monetary policy Basel II Basel III Basel 4

Implementation	Capital control Discount rate Interest rates Money creation Open market operation Sovereign wealth fund

Bretton Woods system

International Monetary Fund World Bank Group International Bank for Reconstruction and Development International Centre for Settlement of Investment Disputes International Development Association International Finance Corporation Multilateral Investment Guarantee Agency

Lists

List of central banks Central banks and currencies of Africa Central banks and currencies of the Caribbean Central banks and currencies of Central America and South America

Names in italics indicate non-sovereign (dependent) territories, former countries, or states with limited recognition

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