Regulatory capital

What Is Regulatory Capital?

Regulatory capital refers to the minimum amount of capital that financial institutions, particularly banks, are required to hold by their governing regulatory bodies. This capital serves as a buffer against potential losses, helping to ensure the stability and solvency of banks and protect depositors. It falls under the broader financial category of banking regulation. The objective of regulatory capital requirements is to mitigate systemic risk and foster confidence in the financial system. These requirements are a cornerstone of prudential supervision, designed to prevent excessive leverage and ensure that banks can absorb unexpected financial shocks without collapsing.

History and Origin

The concept of regulatory capital gained significant international prominence in the aftermath of various financial crises, which exposed vulnerabilities in the global banking system. A pivotal moment leading to formalized regulatory capital standards was the 1974 failure of Bankhaus Herstatt, a German bank, which highlighted the interconnectedness of international financial markets and the need for global banking supervision. This event spurred the creation of the Basel Committee on Banking Supervision (BCBS) by the central bank governors of the Group of Ten (G-10) countries.²⁹,²⁸,²⁷

The BCBS released the first international framework for capital measurement in July 1988, known as the Basel Capital Accord, or Basel I.²⁶,,²⁵ This accord introduced a minimum ratio of capital to risk-weighted assets, aiming to strengthen the stability of the international banking system and address competitive inequalities stemming from differing national capital requirements.²⁴,²³,²² Subsequent iterations, Basel II and Basel III, refined these standards, introducing more sophisticated approaches to risk assessment and expanding the scope of risks covered, particularly in response to the 2008 financial crisis.²¹,

Key Takeaways

• Regulatory capital is the minimum capital banks must hold to absorb losses and maintain stability.
• These requirements are typically set by international bodies like the Basel Committee on Banking Supervision and implemented by national regulators.
• Regulatory capital helps protect depositors and the broader financial system from bank failures.
• It is often expressed as a ratio of capital to risk-weighted assets, ensuring that higher-risk activities require more capital.
• The evolution of regulatory capital frameworks has largely been driven by lessons learned from past financial crises.

Formula and Calculation

Regulatory capital is most commonly calculated as a ratio of a bank's eligible capital to its risk-weighted assets (RWA). The fundamental formula for the capital adequacy ratio (CAR) is:

• Eligible Capital: This typically includes a bank's Tier 1 capital (core capital like common equity and disclosed reserves) and Tier 2 capital (supplementary capital like subordinated debt and general loan loss reserves). Different regulatory frameworks define these tiers with specific inclusions and exclusions.
• Risk-Weighted Assets (RWA): Assets are assigned different risk weights based on their perceived credit risk. For instance, cash or government securities generally have a lower risk weight (e.g., 0%) compared to corporate loans (e.g., 100%) or certain types of derivatives.²⁰, The sum of these risk-weighted assets forms the denominator. This approach ensures that a bank holding riskier assets is required to hold more capital.

Under Basel II and III, there are also considerations for operational risk and market risk, which also contribute to the RWA calculation.

Interpreting the Regulatory Capital

Interpreting regulatory capital involves understanding the ratios that banks are required to maintain. A higher capital adequacy ratio generally indicates a stronger financial position, suggesting a bank has a greater capacity to absorb unexpected losses. Regulators set minimum thresholds for these ratios, and banks are expected to operate above these minimums. For example, under Basel III, the minimum total capital ratio is 8% of RWA, though national regulators often set higher requirements.

Analysts and investors use these ratios to assess a bank's financial health and stability. A bank that consistently maintains capital levels significantly above the regulatory minimum might be viewed as more resilient to economic downturns or market volatility. Conversely, a bank with capital ratios close to the minimums could be considered more susceptible to adverse events, potentially leading to increased scrutiny from regulators and a higher cost of capital.

Hypothetical Example

Consider a hypothetical bank, "Evergreen Trust," with the following simplified balance sheet items relevant to regulatory capital calculation:

• Common Equity Tier 1 (CET1) Capital: $100 million
• Additional Tier 1 Capital: $20 million
• Tier 2 Capital: $30 million
• Cash and Government Bonds (0% risk weight): $50 million
• Mortgage Loans (35% risk weight): $150 million
• Corporate Loans (100% risk weight): $200 million
• Other Assets (50% risk weight): $80 million

First, calculate the Total Eligible Capital:

• Total Eligible Capital = CET1 Capital + Additional Tier 1 Capital + Tier 2 Capital
• Total Eligible Capital = $100 million + $20 million + $30 million = $150 million

Next, calculate the Risk-Weighted Assets (RWA):

• RWA (Cash & Government Bonds) = $50 million * 0% = $0
• RWA (Mortgage Loans) = $150 million * 35% = $52.5 million
• RWA (Corporate Loans) = $200 million * 100% = $200 million
• RWA (Other Assets) = $80 million * 50% = $40 million
• Total RWA = $0 + $52.5 million + $200 million + $40 million = $292.5 million

Finally, calculate the Total Capital Adequacy Ratio:

• Total Capital Adequacy Ratio = (Total Eligible Capital / Total RWA) * 100
• Total Capital Adequacy Ratio = ($150 million / $292.5 million) * 100 ≈ 51.28%

If the regulatory minimum total capital ratio is 8%, Evergreen Trust's ratio of 51.28% far exceeds this requirement, indicating a very strong capital position. This example demonstrates how a bank's asset allocation significantly impacts its RWA and, consequently, its regulatory capital ratios.

Practical Applications

Regulatory capital requirements have several practical applications across the financial industry:

• Risk Management: They incentivize banks to manage their credit risk, market risk, and operational risk more effectively by linking capital requirements to the riskiness of their activities.
• Lending Decisions: Regulatory capital impacts a bank's capacity for lending. When capital requirements increase, banks may need to raise more capital or reduce their lending activities to meet the new thresholds., ¹⁹R¹⁸esearch indicates that higher capital can lead to increased credit at a faster pace and lower funding costs for banks, which can in turn benefit borrowers through lower interest rates.,
  ¹⁷*¹⁶ Mergers and Acquisitions: Banks consider the regulatory capital implications when evaluating mergers and acquisitions. The combined entity must meet the capital requirements, which can influence valuation and deal structure.
• Stress Testing: Regulatory bodies conduct stress tests to assess whether banks have sufficient capital to withstand severe economic downturns. These tests help identify vulnerabilities in the financial system.
• International Standards: The Basel Accords provide a global framework, ensuring a level playing field for internationally active banks and promoting financial stability across borders. The European Union, for instance, has implemented the Basel III framework through its Capital Requirements Regulation (CRR) to ensure banks are sufficiently capitalized.

¹⁵## Limitations and Criticisms

Despite their importance, regulatory capital frameworks face certain limitations and criticisms:

• Regulatory Arbitrage: Banks may engage in "regulatory arbitrage," finding ways to structure their activities or assets to reduce their reported risk-weighted assets without necessarily reducing the actual underlying risk., ¹⁴T¹³his can occur, for example, by shifting assets off-balance sheet or by manipulating asset valuations.,,^{12
  11}*¹⁰ Procyclicality: Capital requirements can be procyclical, meaning they might amplify economic cycles. In an economic downturn, falling asset values and increased defaults can reduce a bank's capital, forcing it to cut lending, which can further exacerbate the downturn. Conversely, in boom times, lower perceived risks might lead to less capital being held, potentially fueling excessive credit growth.
• Complexity: The evolving nature and increasing complexity of regulatory capital rules, particularly with Basel II and Basel III, can be burdensome for banks to implement and for regulators to supervise effectively.,
  ⁹ Impact on Lending: While intended to ensure stability, some argue that overly stringent regulatory capital requirements can constrain bank lending, especially to small and medium-sized enterprises, potentially hindering economic growth.,
  ⁸⁷ One-Size-Fits-All Approach: Critics sometimes argue that a standardized approach to capital requirements might not adequately capture the diverse risk profiles of different banks or financial institutions.

Regulatory Capital vs. Reserve Requirements

Regulatory capital and reserve requirements are both regulatory tools designed to ensure financial stability, but they serve distinct purposes. Regulatory capital dictates the amount of a bank's own funds (equity and certain types of debt) that must be held against its assets to absorb potential losses. It focuses on the solvency of the bank, ensuring it has enough financial cushion to withstand unexpected difficulties and honor its obligations., In essence, regulatory capital governs the liabilities and equity side of a bank's balance sheet.

In contrast, reserve requirements specify the portion of a bank's deposits that it must hold in liquid assets, typically cash or balances at the central bank. The primary purpose of reserve requirements is to ensure liquidity, enabling banks to meet sudden withdrawals by depositors and to facilitate the central bank's control over the money supply., Therefore, while regulatory capital addresses long-term solvency and risk absorption, reserve requirements focus on immediate liquidity needs and monetary policy implementation.

FAQs

Q: What is the primary purpose of regulatory capital?
A: The primary purpose of regulatory capital is to ensure that banks have sufficient financial resources to absorb losses, maintain solvency, and protect depositors, thereby contributing to the stability of the overall financial system.

⁶Q: How do regulators determine the amount of regulatory capital a bank needs?
A: Regulators determine the amount of regulatory capital a bank needs primarily by calculating its risk-weighted assets (RWA). Different assets carry different risk weights, meaning riskier assets require a bank to hold more capital against them.,

⁵Q: What are the main components of regulatory capital?
A: The main components of regulatory capital are typically divided into Tier 1 capital (core capital like common equity and disclosed reserves) and Tier 2 capital (supplementary capital such as subordinated debt).

Q: Does regulatory capital impact a bank's lending activities?
A: Yes, regulatory capital can impact a bank's lending activities. Higher capital requirements may lead banks to reduce lending or seek to raise additional capital, which can affect the availability and cost of credit in the economy.,
^4
3Q: What are the Basel Accords?
A: The Basel Accords are a series of international recommendations on banking regulations issued by the Basel Committee on Banking Supervision. They establish global standards for regulatory capital requirements and other prudential regulations for banks.,,²¹