Capital requirement

Capital requirement

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Capital requirement refers to -
The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

, Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...

 or Federal Reserve Board. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals.
Also known as "regulatory capital".

The Basel Accords, published by the Basel Committee on Banking Supervision
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...

 housed at the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

, sets a framework on how bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

s and depository institution
Depository institution
A depository institution is a financial institution in the United States that is legally allowed to accept monetary deposits from consumers...

s must calculate their capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...

. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...

. This framework has been replaced by a significantly more complex capital adequacy framework commonly known as Basel II
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...

. After 2012 it will be replaced by Basel III
Basel III
BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed upon by the members of the Basel Committee on Banking Supervision. The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial...

 .
Another term commonly used in the context of the frameworks is Economic Capital
Economic capital
-Finance and Economics:In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation....

, which can be thought of as the capital level bank shareholders would choose in absence of capital regulation. For a detailed study on the differences between these two definitions of capital, refer to .

The capital ratio
Capital adequacy ratio
Capital adequacy ratio , also called Capital to Risk Assets Ratio , is a ratio of a bank's capital to its risk...

 is the percentage of a bank's capital to its risk-weighted asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

s. 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 banks 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
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...

 accord, Basel II
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...

 makes significant alterations to the interpretation, if not the calculation, of the capital requirement.

Examples of national regulators implementing Basel II
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...

 include the FSA
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...

 in the UK, BaFin
BaFin
The Federal Financial Supervisory Authority better known by its abbreviation BaFin is the financial regulatory authority for Germany. It is an independent federal institution with headquarters in Bonn and Frankfurt and falls under the supervision of the Federal Ministry of Finance...

 in Germany, OSFI in Canada, Banca d'Italia
Banca d'Italia
Banca d'Italia is the central bank of Italy and part of the European System of Central Banks. It is located in Palazzo Koch, Roma, via Nazionale...

 in Italy.

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). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

 associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments
Unfunded loan commitments
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 events before funding is needed...

, letters of credit, and derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

s 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
Tier 1 capital
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...

 ratio of at least 4%, a combined Tier 1 and Tier 2 capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . 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...

 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
Tier 1 capital
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...

 ratio of at least 6%, a combined Tier 1 and Tier 2 capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . 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...

 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
Call 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. For banks in the U.S., one of the key reports required to be filed is the quarterly Report of Condition and Income, generally...

 or Thrift Financial Report
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 , among other requirements, to file a key quarterly 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
Tangible Common Equity
Tangible Common Equity refers to the subset of shareholders' equity that is not preferred equity and not intangible assets.TCE is an uncommonly used measure of a company’s financial strength. It indicates how much ownership equity owners of common stock would receive in the event of a company’s...

, which is different from Tier 1 capital in that it excludes preferred equity.

Regulatory capital


In the Basel II
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...

 accord bank capital has been divided into two "tiers" ( ), each with some subdivisions.

Tier 1 capital



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. 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 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
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...

), 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.

Tier 2 (supplementary) 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 not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results.

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 may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....

 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 on-going basis without triggering liquidation.

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 4years before maturity). The remainder qualifies as senior issuance. For this reason many Lower Tier 2 instruments were issued as 10yr non-call 5 year issues (i.e. final maturity after 10yrs but callable after 5yrs). 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 that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority
Australian Prudential Regulation Authority
The Australian Prudential Regulation Authority is a statutory authority and the prudential regulator of the Australian financial services industry.-Regulatory scope:...

, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial Services Authority
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...

. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.

Common capital ratios

  • Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6%
  • Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10%
  • Leverage ratio = Tier 1 capital / Average total consolidated assets >=5%
  • Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets

Example


An example of capital ratios can be obtained from the 2010 annual report
Annual report
An annual report is a comprehensive report on a company's activities throughout the preceding year. Annual reports are intended to give shareholders and other interested people information about the company's activities and financial performance...

 of Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...

.

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