Capital requirements

Capital requirements refer to the minimum amount of capital that a bank or other financial institution must hold as required by its financial regulator. These requirements are set to ensure that these institutions can absorb a reasonable amount of loss and comply with their statutory Capital Adequacy Ratios (CARs).

Overview

Capital requirements are a central tool of macroprudential policy. They are often implemented to protect depositors and promote the stability and efficiency of financial systems around the world. The capital requirement for a bank is typically expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These ratios ensure that banks can absorb a reasonable amount of loss before becoming insolvent.

Types of Capital

There are two types of capital that can be distinguished: Tier 1 and Tier 2 capital.

Tier 1 capital is the core capital of a bank, which includes ordinary share capital, disclosed reserves, retained earnings, and other comprehensive income.

Tier 2 capital includes undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.

Basel Accords

The Basel Accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (BCBS). The Accords, namely Basel I, Basel II, and Basel III, set the minimum capital requirements for banks.

Basel I was the first comprehensive attempt to establish minimum capital standards for banks. It focused mainly on credit risk and categorized the assets of a bank into five risk buckets.

Basel II introduced the concept of three pillars: minimum capital requirements, supervisory review, and market discipline. It also introduced the concept of operational risk and improved the calculation of risk weights.

Basel III was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It aims to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

Impact on the Economy

Capital requirements have a significant impact on the economy. They affect the ability of banks to lend, and thus they have implications for the pace of economic growth. Higher capital requirements can lead to a decrease in lending, which can slow economic growth. However, they can also lead to a more stable financial system, which can support sustainable economic growth in the long run.

See Also

• Bank regulation
• Financial stability
• Financial crisis of 2007–08
• Basel Committee on Banking Supervision