Minimum capital requirement
Encyclopedia
Academics, practitioners, and regulator
s all recognise and agree that capital
is required for bank
s to operate smoothly because capital provides protection. The critical question is how much, and what the type of capital a bank needs to hold so that it has adequate protection.
In the simplest form, capital represents the portion of the bank’s asset
s which does not have to be repaid and therefore is available as a buffer in case the value of the bank drops as a result of losses. If banks always made profits, there would be no need for capital. Unfortunately, such ideal world does not exist, so capital is necessary to act as a cushion when banks are impacted by large losses. In the event that the bank’s asset value is lower than its total liabilities, the bank becomes insolvent and equity
holders are likely to choose to default on the bank’s obligations.
Naturally, regulators would hold the view that banks should hold more capital, so as to ensure that insolvency
risk and the consequent system disruptions are minimised. On the other hand, banks would wish to hold the minimum level of capital that supplies adequate protection, since capital is an expensive form of funding
, and it also dilutes earnings.
There are 3 views on what a bank’s minimum capital requirement should be.
. Regulatory capital could be seen as the minimum capital requirement in a “liquidation / runoff” view, whereby, if a bank has to be liquidated, whether all liabilities can be paid off.
Regulatory capital is a standardised calculation for all banks, although, there would be differences to various regulatory regimes. The process by which it is calculated is also transparent, this allows meaningful comparisons between banks under Pillar 3 disclosures.
is the theoretical view on minimum capital requirement based on the underlying risks of the bank’s assets and operations. Economic capital could be seen as the minimum capital requirement in a “going concern
” view, whereby, a bank is in continual operation, and it is only concerned with holding enough capital to ensure its survival.
Economic capital was originally developed by banks as a tool for capital allocation and performance assessment. For these purposes, it did not need to measure risk in an absolute, but only in the relative sense.
Over time, with advances in risk quantification methodologies and the supporting technological infrastructure, the use of economic capital has extended to applications that require accuracy in the measurement of risk. This is evident in the ICAAP, whereby banks are required to quantify the absolute level of internal capital.
Although, economic capital has evolved sufficiently to be used alongside regulatory initiatives, it should remain a hypothetical measurement, and be used primarily as a basis for risk adjusted performance measurement (RAPM/SVA) and risk-based pricing
(RAROC). This is because if economic capital is used to set minimum capital requirement, banks will have a conflict of interest in producing low estimates to minimise its capital holding. And since economic capital modelling is an internal measurement, there is no standardisation across the banking industry, which in turn, makes regulation difficult.
. The amount of capital and the type of capital (Tier 1 & 2) a bank holds in relation to its total risk weighted assets is a crucial input to the mechanism in which rating agencies use to assess a bank’s capital adequacy and its subsequent credit rating. And since credit ratings provide important signals to the market on a bank’s financial strength, they can have significant downstream impact on a bank’s ability to raise funds, and also the cost at which the funds are raised. Therefore, having sufficient capital to meet rating agency requirement becomes an important consideration for senior management.
Rating agency capital differs to regulatory and economic capital in that it seeks to neutralise the impacts of different regulatory regimes, Basel II
options, and individual banks’ risk assessment
s. That is, it aims to provide a globally comparable capital measure.
Regulator
Regulator may refer to:*Regulator , a device that maintains a designated characteristic**Battery regulator**Pressure regulator**Diving regulator**Voltage regulator...
s all recognise and agree that capital
Capital
A capital city is the area of a country, province, region, or state considered to enjoy primary status; although there are exceptions, a capital is typically a city that physically encompasses the offices and meeting places of the seat of government and is usually fixed by law or by the constitution...
is required for 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 to operate smoothly because capital provides protection. The critical question is how much, and what the type of capital a bank needs to hold so that it has adequate protection.
In the simplest form, capital represents the portion of the bank’s 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 which does not have to be repaid and therefore is available as a buffer in case the value of the bank drops as a result of losses. If banks always made profits, there would be no need for capital. Unfortunately, such ideal world does not exist, so capital is necessary to act as a cushion when banks are impacted by large losses. In the event that the bank’s asset value is lower than its total liabilities, the bank becomes insolvent and equity
Equity
Equity is the name given to the set of legal principles, in jurisdictions following the English common law tradition, that supplement strict rules of law where their application would operate harshly...
holders are likely to choose to default on the bank’s obligations.
Naturally, regulators would hold the view that banks should hold more capital, so as to ensure that insolvency
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
risk and the consequent system disruptions are minimised. On the other hand, banks would wish to hold the minimum level of capital that supplies adequate protection, since capital is an expensive form of funding
Funding
Funding is the act of providing resources, usually in form of money , or other values such as effort or time , for a project, a person, a business or any other private or public institutions...
, and it also dilutes earnings.
There are 3 views on what a bank’s minimum capital requirement should be.
Regulatory View
Regulatory capital is the minimum capital requirement as demanded by the regulators; it is the amount a bank must hold in order to operate. A regulator’s primary concern is that there is insufficient capital to buffer a bank against large loss so that deposits are at risk, with the possibility of leading to further disruption in the financial systemFinancial system
In finance, the financial system is the system that allows the transfer of money between savers and borrowers. A financial system can operate on a global, regional or firm specific level...
. Regulatory capital could be seen as the minimum capital requirement in a “liquidation / runoff” view, whereby, if a bank has to be liquidated, whether all liabilities can be paid off.
Regulatory capital is a standardised calculation for all banks, although, there would be differences to various regulatory regimes. The process by which it is calculated is also transparent, this allows meaningful comparisons between banks under Pillar 3 disclosures.
Economic View
Economic capitalEconomic 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....
is the theoretical view on minimum capital requirement based on the underlying risks of the bank’s assets and operations. Economic capital could be seen as the minimum capital requirement in a “going concern
Going concern
A going concern is a business that functions without the threat of liquidation for the foreseeable future, usually regarded as at least within 12 months.-Definition of the 'going concern' concept:...
” view, whereby, a bank is in continual operation, and it is only concerned with holding enough capital to ensure its survival.
Economic capital was originally developed by banks as a tool for capital allocation and performance assessment. For these purposes, it did not need to measure risk in an absolute, but only in the relative sense.
Over time, with advances in risk quantification methodologies and the supporting technological infrastructure, the use of economic capital has extended to applications that require accuracy in the measurement of risk. This is evident in the ICAAP, whereby banks are required to quantify the absolute level of internal capital.
Although, economic capital has evolved sufficiently to be used alongside regulatory initiatives, it should remain a hypothetical measurement, and be used primarily as a basis for risk adjusted performance measurement (RAPM/SVA) and risk-based pricing
Risk-based pricing
Risk-based pricing is a methodology adopted by many lenders in the mortgage and financial services industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees...
(RAROC). This is because if economic capital is used to set minimum capital requirement, banks will have a conflict of interest in producing low estimates to minimise its capital holding. And since economic capital modelling is an internal measurement, there is no standardisation across the banking industry, which in turn, makes regulation difficult.
Rating Agency View
Rating agency capital is the minimum capital a bank needs to hold in order to meet a certain credit ratingCredit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
. The amount of capital and the type of capital (Tier 1 & 2) a bank holds in relation to its total risk weighted assets is a crucial input to the mechanism in which rating agencies use to assess a bank’s capital adequacy and its subsequent credit rating. And since credit ratings provide important signals to the market on a bank’s financial strength, they can have significant downstream impact on a bank’s ability to raise funds, and also the cost at which the funds are raised. Therefore, having sufficient capital to meet rating agency requirement becomes an important consideration for senior management.
Rating agency capital differs to regulatory and economic capital in that it seeks to neutralise the impacts of different regulatory regimes, 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...
options, and individual banks’ risk assessment
Risk assessment
Risk assessment is a step in a risk management procedure. Risk assessment is the determination of quantitative or qualitative value of risk related to a concrete situation and a recognized threat...
s. That is, it aims to provide a globally comparable capital measure.