Own funds

What Are Own Funds?

Own funds, in the context of financial regulation and banking regulation, refer to the sum of a financial institution's capital and certain other instruments that are available to absorb losses, both in going concern and gone concern situations. They represent the resources that a bank, for example, possesses to withstand financial shocks and ensure financial stability. These funds are crucial for maintaining the solvency of financial institutions and are a cornerstone of prudential supervision designed to protect depositors and the broader banking system. The concept of own funds is central to global regulatory frameworks, such as Basel III, which aim to strengthen the resilience of banks.

History and Origin

The concept of own funds has evolved significantly over decades, primarily driven by a series of international accords aimed at preventing financial crises. Before standardized regulations, capital adequacy was often assessed on a case-by-case basis by regulators. The need for uniform and specific capital standards became evident in the 1980s. The Basel Committee on Banking Supervision (BCBS), established in 1974 by central bank governors of the Group of Ten (G10) countries, began developing international standards for bank capital.,²⁴

The first iteration, Basel I, introduced in 1988, established a basic framework for minimum capital requirements based on credit risk. Basel II, implemented in 2004, expanded on this by incorporating market risk and operational risk, emphasizing stronger risk management practices and internal controls. However, the global financial crisis of 2008 exposed significant weaknesses in the existing regulatory framework, particularly regarding the quantity and quality of capital held by banks to absorb unexpected losses.,²³,²²

In response to these deficiencies, the BCBS developed Basel III, which was published in 2010 and began implementation in 2012.,²¹ This comprehensive framework significantly raised the minimum capital requirements for banks, improved the quality of capital, introduced new capital buffers, and established global liquidity and leverage ratio standards. The reforms were designed to make banks more resilient and restore confidence in banking systems.²⁰ The European Banking Authority (EBA), for instance, develops regulatory technical standards that specify the quality criteria for institutions' regulatory own funds.¹⁹

Key Takeaways

• Own funds are the financial resources, primarily capital and certain other instruments, that a financial institution uses to absorb losses.
• They are a critical component of regulatory frameworks designed to ensure the solvency and stability of banks and protect depositors.
• The composition and requirements for own funds are largely defined by international standards, such as Basel III, and implemented by national and supranational authorities.
• The adequacy of own funds is assessed through various metrics, including risk-based ratios and non-risk-based leverage ratios.
• Regulators continuously refine the rules around own funds to balance financial stability with potential impacts on lending and economic growth.

Formula and Calculation

While "own funds" isn't a single formula itself, it represents the sum of distinct components of regulatory capital adequacy. Under frameworks like Basel III, own funds are primarily composed of:

• Tier 1 Capital: This is the highest quality of capital, capable of absorbing losses on an ongoing basis. It is further divided into:
  • Common Equity Tier 1 (CET1): This is the purest and most reliable form of capital, consisting mainly of common stock and retained earnings.¹⁸,¹⁷,¹⁶ It is fully available to absorb losses.
  • Additional Tier 1 (AT1): This includes instruments that are perpetual (no fixed maturity date) and callable only at the issuer's option, providing a buffer that can absorb losses without triggering insolvency.
• Tier 2 Capital: This consists of instruments that absorb losses in the event of a winding-up of the bank (gone concern). It typically includes subordinated debt with an original maturity of at least five years.

The total own funds are calculated as:

From these own funds, various deductions and adjustments are applied according to regulatory rules (e.g., investments in other financial institutions, deferred tax assets). The resulting figure is then used to calculate capital ratios against risk-weighted assets (RWAs) and total assets.

Interpreting the Own Funds

The interpretation of own funds primarily revolves around assessing a financial institution's capacity to absorb losses and its compliance with regulatory requirements. A higher level of own funds, particularly in the form of high-quality capital like Common Equity Tier 1 (CET1), indicates greater resilience. Regulators set minimum thresholds for own funds relative to a bank's balance sheet and its risk exposures.

For instance, capital ratios (e.g., CET1 ratio, Tier 1 ratio, Total Capital Ratio) express own funds as a percentage of risk-weighted assets. A bank with a 12% CET1 ratio, for example, means that its highest quality capital amounts to 12% of its risk-weighted assets. These ratios are closely monitored; falling below regulatory minimums can trigger restrictions on dividends, bonus payments, and other distributions. The Federal Reserve, for example, announces individual capital requirements for large banks, which include a minimum CET1 capital requirement and a stress capital buffer.¹⁵,¹⁴,¹³

Beyond risk-weighted ratios, the leverage ratio provides a non-risk-based measure, comparing Tier 1 capital to a bank's total unweighted assets. This offers a simpler perspective on the overall amount of own funds relative to the institution's size, acting as a backstop to risk-weighted measures.

Hypothetical Example

Consider "Horizon Bank," a hypothetical financial institution.

Horizon Bank's balance sheet includes:

• Common Stock: $500 million
• Retained Earnings: $300 million
• Additional Tier 1 Instruments: $100 million
• Tier 2 Capital Instruments: $150 million
• Total Assets: $10 billion
• Risk-Weighted Assets (RWAs): $5 billion

To calculate Horizon Bank's own funds:

1. Common Equity Tier 1 (CET1):
   CET1 = Common Stock + Retained Earnings
   CET1 = $500 million + $300 million = $800 million

2. Total Tier 1 Capital:
   Total Tier 1 = CET1 + Additional Tier 1 Instruments
   Total Tier 1 = $800 million + $100 million = $900 million

3. Total Own Funds:
   Total Own Funds = Total Tier 1 Capital + Tier 2 Capital Instruments
   Total Own Funds = $900 million + $150 million = $1.05 billion

Now, let's look at its capital ratios:

• CET1 Ratio:
  ( \text{CET1 Ratio} = \frac{\text{CET1 Capital}}{\text{Risk-Weighted Assets}} = \frac{$800 \text{ million}}{$5 \text{ billion}} = 16% )

• Total Capital Ratio:
  ( \text{Total Capital Ratio} = \frac{\text{Total Own Funds}}{\text{Risk-Weighted Assets}} = \frac{$1.05 \text{ billion}}{$5 \text{ billion}} = 21% )

• Leverage Ratio:
  ( \text{Leverage Ratio} = \frac{\text{Total Tier 1 Capital}}{\text{Total Assets}} = \frac{$900 \text{ million}}{$10 \text{ billion}} = 9% )

If regulatory requirements stipulate a minimum CET1 ratio of 4.5%, a total capital ratio of 8%, and a leverage ratio of 3%, Horizon Bank's own funds appear robust and exceed these minimums, indicating a strong capital position. This robust position allows the bank to absorb potential losses from its liabilities without becoming insolvent.

Practical Applications

Own funds are fundamental to the global financial system, underpinning various aspects of banking and regulation:

• Regulatory Compliance: Banks are legally mandated to maintain certain levels of own funds to comply with local and international prudential regulations, such as those derived from the Basel Accords. Supervisory bodies like the European Banking Authority (EBA) and the Federal Reserve enforce these requirements.¹²,¹¹ These requirements are dynamic and subject to ongoing adjustments and reviews by regulatory bodies.¹⁰
• Loss Absorption: The primary purpose of own funds is to act as a buffer against unexpected losses arising from credit defaults, market fluctuations, or operational failures. Higher quality and quantity of own funds mean a bank can absorb greater shocks without resorting to public bailouts or failing.
• Risk Management and Stress Testing: The calculation of own funds and associated ratios informs a bank's internal risk management frameworks. Regulators use stress tests to assess whether a bank's own funds would be sufficient to withstand severe economic downturns.⁹,⁸
• Market Confidence: Adequate own funds signal financial strength to investors, creditors, and depositors, enhancing market confidence and reducing the perceived risk of a bank run or failure. This directly impacts a bank's funding costs and its ability to raise additional equity or debt.
• Capital Allocation: The amount of own funds a bank holds influences its capacity to extend new loans, make investments, and engage in other income-generating activities. Banks with higher own funds typically have greater flexibility in their strategic decisions and growth initiatives.

Limitations and Criticisms

While own funds requirements are crucial for financial stability, they are not without limitations and criticisms:

• Complexity: The regulatory framework surrounding own funds, particularly with risk-weighted asset calculations, has become exceedingly complex. Critics argue this complexity can obscure actual risks, create opportunities for regulatory arbitrage, and is difficult for the public to understand.⁷
• Procyclicality: Some economists argue that strict capital requirements can be procyclical, meaning they might amplify economic cycles. During economic downturns, banks may need to increase their capital ratios, potentially by reducing lending or selling assets, which could further dampen economic activity. However, proponents argue that higher capital buffers actually enable banks to lend more during stressed periods.⁶
• Impact on Lending: There is ongoing debate about whether higher own funds requirements unduly restrict bank lending, particularly to small and medium-sized enterprises (SMEs), by making credit more expensive or less available. Industry groups and some policymakers have voiced concerns that proposed stricter capital rules could harm the overall economy and reduce credit availability.⁵,⁴
• Doesn't Guarantee Stability: Despite increased capital requirements, financial instability can still arise from other factors, such as liquidity crises or market contagion, as evidenced by recent banking sector events.³
• Regulatory Arbitrage: The intricate nature of calculating risk-weighted assets can incentivize banks to engage in regulatory arbitrage, structuring their activities to minimize reported risk exposure rather than truly reducing underlying risk.

Own Funds vs. Capital Requirements

The terms "own funds" and "capital requirements" are closely related but distinct within the financial regulatory landscape.

Own funds refer to the actual financial resources that a bank or financial institution possesses, comprising various tiers of capital and eligible instruments. It is the stock of available capital that can absorb losses. Essentially, own funds are what a bank has.

Capital requirements, on the other hand, are the regulatory mandates specifying the minimum amount of own funds that a bank must hold relative to its risk exposures or total assets. These are the rules dictating how much capital a bank needs. Regulatory bodies, like the Federal Reserve, periodically announce these requirements for large banks, outlining the minimum percentages and additional buffers they must maintain.²,¹

Think of it this way: if own funds are the money in your wallet, capital requirements are the minimum amount of money the law says you must carry when you go out. A bank's own funds must meet or exceed its capital requirements to be considered compliant and financially sound.

FAQs

What is the primary purpose of own funds for banks?

The primary purpose of own funds is to provide a financial cushion that allows banks to absorb unexpected losses from their operations, investments, or loans without becoming insolvent or requiring taxpayer bailouts. This ensures the stability and safety of the financial system.

How are own funds categorized?

Own funds are generally categorized into two main tiers: Tier 1 Capital (the highest quality, including Common Equity Tier 1 and Additional Tier 1) and Tier 2 Capital (lower quality, absorbing losses in a liquidation scenario).

What happens if a bank's own funds fall below regulatory requirements?

If a bank's own funds fall below its regulatory capital requirements, it typically faces automatic restrictions on activities such as dividend payments, share buybacks, and discretionary bonus payments. Regulators may also impose stricter supervision, require a capital restoration plan, or even intervene directly to ensure compliance and prevent failure.

Do own funds only apply to banks?

While most prominently discussed in the context of banks, similar concepts of capital adequacy and "own funds" apply to other regulated financial entities, such as insurance companies and investment firms, adapted to their specific risk profiles and regulatory frameworks.

How do own funds contribute to economic stability?

By ensuring banks have sufficient buffers to absorb losses, own funds reduce the likelihood of bank failures. This prevents contagion across the financial system, protects depositors, and maintains the flow of credit to the economy, all of which are vital for overall economic stability.