What Are Capital Requirements?
Capital requirements are standardized regulations for banks and other depository institutions that determine how much liquid capital (that is, easily sold securities) must be held viv-a-vis a certain level of their assets.
Also known as regulatory capital, these standards are set by regulatory agencies, such as the Bank for International Settlements (BIS), the Federal Deposit Insurance Corporation (FDIC), or the Federal Reserve Board (the Fed).
An angry public and uneasy investment climate usually prove to be the catalysts for legislative reform in capital requirements, especially when irresponsible financial behavior by large institutions is seen as the culprit behind a financial crisis, market crash, or recession.
Key Takeaways
- Capital requirements are regulatory standards for banks that determine how much liquid capital (easily sold assets) they must keep on hand, concerning their overall holdings.
- Expressed as ratios, the capital requirements are based on the weighted risk of the banks' different assets.
- In the U.S., adequately capitalized banks have a tier 1 capital-to-risk-weighted assets ratio of at least 4.5%.
- Capital requirements are often tightened after an economic recession, stock market crash, or another type of financial crisis.
Understanding Capital Requirements
Capitalrequirements are set to ensure bank and depository institution holdings are not dominated by investments that increase the risk of default. They also ensure that banks and depository institutions have enough capital to sustain operating losses (OL) while still honoring withdrawals.
In the United States, the capital requirement for banks is based on several factors but is mainly focused on the weighted risk associated with each type of asset the bank holds. These risk-based capital requirements guidelines are used to create capital ratios, which can then be used to evaluate lending institutions based on their relative strength and safety.
An adequately capitalized institution, based on the Federal Deposit Insurance Act, must have a tier 1 capital-to-risk-weighted assets ratio of at least 4.5%. Typically, tier 1 capital includes common stock, disclosed reserves, retained earnings, and certain types of preferred stock. Institutions with a ratio below 4.5% are considered undercapitalized.
Advantages and Disadvantages of Capital Requirements
Capital requirements aim not only to keep banks solvent but, by extension, to keep the entire financial system on a safe footing. In an era of national and international finance, no bank is an island, as regulatory advocates note—a shock to one can affect many. So, all the more reason for stringent standards that can be applied consistently and used to compare the different soundness of institutions.
Still, capital requirements have their critics. They charge that higher capital requirements have the potential to reduce bank risk-taking and competition in the financial sector (on the basis that regulations always prove costlier to smaller institutions than to larger ones).
By mandating banks to keep a certain percentage of assets liquid, the requirements can inhibit the institutions' ability to invest and make money—and thus extend credit to customers. Maintaining certain capital levels can increase their costs, which in turn increases costs for borrowing or other services for consumers.
Pros
Ensure banks stay solvent, avoid default
Ensure depositors have access to funds
Set industry standards
Provide a way to compare, evaluate institutions
Cons
Raise costs for banks and eventually consumers
Inhibit banks' ability to invest
Reduce availability of credit, loans
History of Capital Requirements
Global capital requirements have swung higher and lower over the years. They tend to increase following a financial crisis or economic recession. Before the 1980s, there were no general capital adequacy requirements on banks. Capital was only one of many factors used in the evaluation of banks, and minimums were tailored to specific institutions.
When Mexico declared in 1982 that it would be unable to service interest payments on its national debt, it sparked a global initiative that led to legislation such as the International Lending Supervision Act of 1983.
Through this legislation and the support of major U.S., European, and Japanese banks, the 1988 Basel Committee on Banking Regulation and Supervisory Practices announced that, for internationally active commercial banks, adequate capital requirements would be raised from 5.5% to 8% of total assets. It was followed by Basel II in 2004, which incorporated types of credit risk in the calculation of ratios.
Per Basel III, the total capital ratio has to be 8% or higher.
However, as the 21st century advanced, a system of applying a risk weight to different types of assets allowed banks to hold less capital with total assets. Traditional commercial loans were given a weight of 1 (100%). The one weight meant that for every $1 of commercial loans held on a bank's balance sheet, they would be required to maintain eight cents of capital.
However, standard residential mortgages were given a weight of 0.5 (50%), mortgage-backed securities (MBS) issued by Fannie Mae or Freddie Mac were given a weight of 0.2 (20%), and short-term government securities were given a weight of 0. By managing assets accordingly, major banks could maintain lower capital ratios than before.
The global financial crisis of 2008 provided the impetus for the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Created to ensure that the largest U.S. banks maintain enough capital to withstand systematic shocks to the banking system, Dodd-Frank—specifically, a section known as the Collins Amendment—set the tier 1 risk-based capital ratio at 4.5%.
Globally, the Basel Committee on Banking Supervision released Basel III, regulations that further tighten capital requirements on financial institutions worldwide.
What Is the Difference Between a Capital Requirement and a Reserve Requirement?
A capital requirement stipulates how much capital a bank must hold while a reserve requirement specifies how much in liquid assets a bank must hold. Capital requirements help soften the losses on loans and other assets while reserve requirements are meant to ensure banks are able to pay depositors and prevent a run on the bank.
Why Do Banks Have Capital Requirements?
Banks have capital requirements in order to reduce the negative impact of losses on investments. All banks make investments, these investments can result in losses. To ensure a bank is operational despite losses, they need to abide by capital requirements.
What Is Basel III's Requirement for Capital?
Basel III requires that banks have a common equity tier 1 to risk-weighted assets ratio of 4.5%.
The Bottom Line
Capital requirements are intended to keep banks from operating in too risky a manner, thereby preventing their possible collapse in the event of market turmoil. The overall arching goal is to ensure the money of depositors is kept safe.
As a result of the various financial calamities in the 21st century, there have been a string of regulations passed to strengthen the capital requirements of banks. These regulations are constantly evolving in a way to allow banks to operate profitably while keeping customers safe.
