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A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming Insolvency. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds, not a use of funds.
From the 1880s to the end of the First World War, the capital-to-assets ratios globally declined sharply, before remaining relatively steady during the 20th century.
The main international effort to establish rules around capital requirements has been the Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements. This sets a framework on how and depository institutions must calculate their capital. After obtaining the capital ratios, the bank capital adequacy can be assessed and regulated. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I. In June 2004 this framework was replaced by a significantly more complex capital adequacy framework commonly known as Basel II. Following the 2008 financial crisis, Basel II was to be replaced by Basel III, however this was completed only in some countries and is scheduled to be completed in others in 2025 and 2026. Implementation of the (also known as Basel 3.1 or Basel III Endgame), introduced in 2017, was extended several times, and is now scheduled to go into effect on July 1, 2025 with a three-year phase-in period.
Another term commonly used in the context of the frameworks is economic capital, which can be thought of as the capital level bank shareholders would choose in the absence of capital regulation.A detailed study on the differences between these two definitions of capital:
The capital ratio is the percentage of a bank's capital to its risk-weighted assets. 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 bank's capital eroded by the yearly inflation rate.
The five Cs of Credit—Character, Cash Flow, Collateral, Conditions and Covenants—have been replaced by one single criterion. While the international standards of bank capital were established in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.
Examples of national regulators implementing Basel include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy. In the United States the primary regulators implementing Basel include the Office of the Comptroller of the Currency and the Federal Reserve.
In the European Union member states have enacted capital requirements based on the Capital Adequacy Directive CAD1 issued in 1993 and CAD2 issued in 1998.
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 associated with assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage financial ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital 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 ratio of at least 6%, a combined Tier 1 and Tier 2 capital 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 or Thrift 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, which is different from Tier 1 capital in that it excludes preferred equity.
Regulatory capital requirements typically (although not always) are imposed at both an individual bank entity level and at a group (or sub-group) level. This may therefore mean that several different regulatory capital regimes apply throughout a bank group at different levels, each under the supervision of a different regulator.
each with some subdivisions.
In India, the Tier 1 capital is defined as "'Tier I Capital' means "owned fund" as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a systemically important non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;" (as per Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007) In the context of NBFCs in India, the Tier I capital is nothing but net owned funds.
Owned funds stand for paid up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any.
Sometimes, it includes instruments which are initially issued with interest obligation (e.g. debentures) but the same can later be converted into capital.
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, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Prudential Regulation Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.
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