Capital Requirements

What Are Capital Requirements?

Capital requirements are standardized regulations in place 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.

The Basics of Capital Requirements

Capital requirements are set to ensure that banks and depository institutions' 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 held by the bank. 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%. Typically, Tier 1 capital includes common stock, disclosed reserves, retained earnings and certain types of preferred stock. Institutions with a ratio below 4% are considered undercapitalized, and those below 3% are significantly undercapitalized.

Capital Requirements: Benefits and Drawbacks

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 levels of capital can increase their costs, which in turn increases costs for borrowing or other services for consumers.

Real World Examples 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. The 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.

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. 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, mortgage-backed securities (MBS) issued by Fannie Mae or Freddie Mac were given a weight of 0.2, 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 of 4% mentioned above. Globally, the Basel Committee on Banking Supervision released Basel III, regulations which further tighter capital requirements on financial institutions worldwide.