Capital Requirements

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  Banking on Basel

  The Future of International Financial Regulation

  • Daniel K. Tarullo(Author)
  • 2008(Publication Date)
  • Peterson Institute for International Economics

    (Publisher)

  23 These factors are very hard to quantify. But that fact just empha-sizes that no financial model, whatever its sophistication, can provide an unassailable formula for Capital Requirements. Third, precisely because of the difficulties in making such determinations, minimum regulatory capi-tal requirements should not be confused with optimal capital levels. 24 The foregoing mention of probability functions of bank insolvencies returns us to the second issue identified at the beginning of this section— the measurement of risks that have been, or might be, assumed by banks. The trade-off between bank stability and reduced financial intermediation can only be assessed if one knows how much stability (i.e., reduction in chances of bank insolvency) one will buy with a particular capital require-ment. While regulators have been generally vague or evasive on the first question of how much stability they want to achieve (and why), they have become progressively more focused on accurate assessments of what it will take to achieve a given level of stability. In fact, Basel II is almost en-tirely an effort to more accurately calibrate the risks faced by banks. A bank is exposed to various risks that could spell serious trouble for its continued solvency. The taxonomy of bank risks is extensive and can vary among analysts. Most obvious and, traditionally at least, most im-portant is the credit risk that its borrowers will not repay their loans in a full and timely fashion. Market risk, the potential for decline in the mar-ket value of assets, becomes more significant as a higher proportion of a bank’s assets is traded rather than lent, whether in a universal bank or as a result of a commercial bank’s business in financial instruments such as derivatives.

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  Understanding Risk

  The Theory and Practice of Financial Risk Management

  • David Murphy(Author)
  • 2008(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  275 C H A P T E R 7 Bank Regulation and Capital Requirements INTRODUCTION There is fairly general agreement on the benefits of some regulation in the financial system [and a further discussion of the motivations for bank regulation can be found in section 1.5.1]. In this chapter, we turn to the structure of the international regulatory framework and discuss its main features, focussing in particular on regulatory capital. Before review-ing the precise rules, however, it might be helpful to discuss certain dilemmas in setting Capital Requirements. HOW DETAILED AND RISK SENSITIVE SHOULD Capital Requirements BE? Regulatory capital is intended to protect the stability of the banking system. A priori , it is not clear that the best way to do this is to align it with best practice in economic capital, for several reasons: First, if regulatory capital is highly risk sensitive, then Capital Requirements will rise in a given country as the economy turns into recession and default probabilities rise. This may cause banks to rein in lending, and hence make recovery from recession more diffi cult. Risk-sensitive Capital Requirements are by their very nature procyclical , and this may not be in the best interests of the economy as a whole. When regulators prescribe the details of risk-based Capital Requirements, they reduce the diversity of behaviour in the financial system. If every bank uses the same kind of model, they will all have an incentive to act the same way, potentially intensifying asset price bubbles and market crashes. [This phenomenon is discussed further in Chapter 9.] Detailed capital rules also stifle innovation in capital modelling since for them to be effective, regulators must continually revise capital rules to deal with the latest prod-ucts and with market changes. • • •

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  Handbook of Basel III Capital

  Enhancing Bank Capital in Practice

  • Juan Ramirez(Author)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  Chapter 2 Minimum Capital Requirements

  Any financial institution subject to Basel III regulations is required to hold certain types and amounts of capital to help it meet its obligations as they fall due. This chapter addresses the minimum Capital Requirements for banks. It is important to note that minimum Capital Requirements are not uniform across all banks: they depend on several factors including the jurisdiction where the bank operates and its presence in the domestic and global financial marketplace.

  2.1 COMPONENTS AND MINIMUM REQUIREMENTS OF BANK CAPITAL

  Both Pillar 1 and Pillar 2 result in Capital Requirements for the bank. Pillar 1 sets out the capital needed to absorb unexpected losses or asset impairments stemming from credit risk, counterparty credit risk, market risk and operational risk. Pillar 2 covers the consideration of whether additional capital is required over and above the Pillar 1 Capital Requirements.

  2.1.1 Pillar 1 Capital Requirements

  According to Basel III, a bank's regulatory capital is divided into several categories or tiers of capital, which try to group constituents of capital depending on their degree of permanence and loss absorbency, as shown in Figure 2.1 .

  FIGURE 2.1

  Components of a bank's regulatory total capital

  Tier 1 capital is so called because it is the best‐quality capital from the regulator's perspective. The objective of Tier 1 capital is to absorb losses and help banks to remain “going concerns” (i.e., to remain solvent, or in other words, to prevent failures). There are two layers of Tier 1 capital:

  • Common Equity Tier 1 capital (“CET1”), which includes permanent shareholders' equity; and
  • Additional Tier 1 capital (“AT1”), which includes some instruments with ability to absorb losses.

  Tier 2 capital, a supplementary capital with less loss absorption capabilities, is aimed at providing loss absorption on a “gone concern

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  The Valuation of Financial Companies

  Tools and Techniques to Measure the Value of Banks, Insurance Companies and Other Financial Institutions

  • Mario Massari, Gianfranco Gianfrate, Laura Zanetti(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  3 The Regulatory Capital for Banks One of the key aspects that sets the valuation of financial firms apart from the val-uation of non-financial companies is the heavy regulation of the capital structure. The presence of specific and detailed Capital Requirements − defined at interna-tional level and enacted by the national banking authorities − affects not only the way banks manage their operations but also how much equity they should retain to meet the relevant requirements. This means that compliance with capital reg-ulations − more than managerial discretion − defines how much income or cash is actually “freely” distributable to bank shareholders. Therefore, when applying valuation approaches like the DDM or the DCF, income, dividends, and cash flow forecasts should take into account how regulatory capital will evolve. Analogously, adjustments to multiple valuations of banks may be appropriate when the capital is significantly distant – either in excess or in deficit − from the level that regulators and investors consider adequate. This is why the regulation of capital is paramount for bank value and valuation. This chapter begins by examining the main features of the relevant capital requirement regulation, and of the capital structure and asset base definitions according to the Basel II framework. It then looks at how management can actively work towards a capital structure assumed to be adequate by both regulators and investors. The last part presents the main changes expected to be introduced by the forthcoming Basel III framework. 3.1 REGULATORY Capital Requirements Banking regulations can vary widely across nations and jurisdictions, but every-where a certain form of regulation is actually in place. The rationale behind regulating banks is that, because of their interconnectedness and the reliance that the national (and global) economies hold on banks, it is important for regula-tory actors to maintain control over the practices of these institutions.

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  The Management of Consumer Credit

  Theory and Practice

  • S. Finlay(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Capital Requirements are reserves, in addition to provision that deposit taking institutions maintain to cover unexpected losses. The BASEL II Capital Accord is an international agreement, drawn up by the Bank for International Settlements (BIS) based in Basel, Switzerland. The accord specifies how deposit taking institutions should go about calculating their Capital Requirements. The accord only applies to deposit taking institu- tions such as banks and saving and loan companies. Non-deposit taking institutions, such as finance houses and pawnbrokers are not covered by the accord and are not required to maintain capital reserves. The accord is based on three core principles or ‘Pillars’: • Pillar 1. Minimum Capital Requirements. This is the capital an insti- tution must maintain to cover unexpected losses to their assets. For the majority of retail banking institutions the most important assets used to calculate Capital Requirements are their credit portfolios. However, other risks are also covered. For example, devaluation of land and foreign currency holdings, and losses resulting from terrorist attack and natural disasters. • Pillar 2. Regulatory response. This covers the role of banking regulators in ensuring that organizations maintain sufficient capital. Regulators are required to audit how organizations make their assessments of risk and hence their Capital Requirements. Regulators may specify that additional capital is needed to cover risks that an organization has not considered, or to address any shortcomings with the methods or data used in Capital Requirements calculations. • Pillar 3. Disclosure. This is concerned with the information that an organization must release to the market about the risks it faces, and how it has calculated its capital requirement. The full accord is extremely complex, contains hundreds of paragraphs, and comes with thousands of pages of supporting documentation.

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  Unsettled Account

  The Evolution of Banking in the Industrialized World since 1800

  • Richard S. Grossman(Author)
  • 2010(Publication Date)
  • Princeton University Press

    (Publisher)

  Simi-larly, the Danish law of 1919 was the result of a decade of investigation following the banking crisis of 1907–8. The delay between the estab-lishment of an investigative committee and the enactment of regulatory reform reflects, in part, the intervention of interest groups that attempted to slow down or alter the reforms. Canadian Capital Requirements were also aimed at maintaining banking stability, by codifying existing high capital standards, but also protected the banking establishment by dis-couraging entry. In a number of instances, new Capital Requirements were an ancillary part of much broader banking reforms. In the United States (1863–64) and in Belgium (1935), Capital Requirements were introduced in the con- Regulation • 155 text of sweeping banking reforms, although the Capital Requirements themselves were not the most noteworthy aspect of those reforms. The change in U.S. Capital Requirements in 1900 was clearly the result of po-litical economy motives, as the federal government tried to beat back competition from state-chartered banking systems. In Germany, Italy, and Japan, setting Capital Requirements was part of establishing a new order in banking—in Japan, encouraging and accelerating a process al-ready under way toward consolidation, and in Italy and Germany, to-ward greater state control of the banking sector. The Impact of Government Capital Requirements Although it seems that government regulation should lead to higher capital-to-asset ratios, a cursory examination of the data suggests that it did not. Figure 6.3 presents average capital-to-asset ratios for countries with and without Capital Requirements. Before the end of World War I, banks in countries without specific Capital Requirements held higher capital-to-asset ratios than countries in which there were capital require-ments; the averages converge during World War I and are not appreciably different during the interwar period.

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  Global Financial Development Report 2019/2020

  Bank Regulation and Supervision a Decade after the Global Financial Crisis

  • World Bank(Author)
  • 2020(Publication Date)
  • World Bank

    (Publisher)

  Thus countercyclical capital re-quirements may help reduce the negative ef-fects on lending. Conversely, approaches such loan losses and increased Capital Requirements contributed to a contraction in the supply of credit for banks (Bernanke and Lown 1991; Berger and Udell 1994; Hancock, Laing, and Wilcox 1995; Peek and Rosengren 1995a, 1995b). Similarly, other studies exploiting a series of natural experiments as sources of ex-ogenous capital shocks reach similar findings. Peek and Rosengren (1997) find that a nega-tive capital shock in Japan was transmitted to Japanese bank branches in the United States. In response, those branches significantly re-duced their lending to U.S. firms that were not affected by the shock. Recent empirical evidence further corrobo-rates that banks reduce their lending as capi-tal requirements increase. Aiyar, Calomiris, and Wieladek (2015) argue that because rais-ing equity is costly, banks often opt to reduce their lending when they need to raise their equity-to-asset ratios. Brun, Fraisse, and Thes-mar (2013) find that in France, when banks transitioned from Basel I to Basel II, their cap-ital requirements fell by 2 percent, which led to a 10 percent increase in loan size and sub-stantial increases in employment and invest-ment. In the United Kingdom, a 1 percentage point increase in required equity ratios was found to contract lending in the short term by approximately 6 percent (Aiyar, Calomiris, and Wieladek 2015). Gropp et al. (2019) ex-ploit a capital exercise conducted in 2011 by the European Banking Authority (EBA) on a subset of European banks to identify the im-pact of higher Capital Requirements on capi-tal ratios and lending. The authors document that the banks subject to this exercise engaged in asset shrinking by reducing their exposures to corporate and retail borrowers. Some scholars, however, argue that there are ways to increase Capital Requirements while limiting the effects on loan supply.

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  Financial Stability and Central Banks

  A Global Perspective

  • Richard Brearley, Juliette Healey, Peter J N Sinclair, Charles Goodhart, David T. Llewellyn, Chang Shu(Authors)
  • 2001(Publication Date)
  • Routledge

    (Publisher)

  19 It also has the advantage that it is patient capital that cannot easily be redeemed by the holders in the event of a banking crisis. Not surprisingly, therefore, bank regulation has focused heavily on Capital Requirements.

  Capital Requirements also have an important potential disadvantage, for a binding capital constraint may cause the bank to reduce its lending and so lead to the credit crunch that regulation was designed to avoid.20 Indeed, it has been suggested that the scramble by US banks to meet the standards of the 1988 Basel Accord led to the US credit crunch of the early 1990s.21 Some more reassuring evidence is provided by Ediz, Michael and Perraudin (1998), who found that, as UK banks approached the capital constraint, they boosted their capital ratios principally by increasing Tier 1 capital, though they also shifted their assets to those with lower risk weightings.

  5.3.2 Are capital constraints binding?

  Capital Requirements would serve little purpose if banks wished to hold more than the required level of capital. It does appear that, in the absence of any government safety net or deposit insurance, banks have an incentive to demonstrate to depositors that they have a sufficient equity buffer. Thus, in 1840 before government regulation, US banks voluntarily held equity in excess of 50 per cent of assets. As depositors increasingly acquired protection against bank failure, this ratio declined to about 10 per cent,22 which is significantly less than the amount of equity maintained by finance companies, which do not enjoy implicit or explicit government guarantees.

  Capital Requirements seem to have contributed to stemming this decline in bank equity. For example, the average risk-weighted capital ratio of G-10 banks rose from 9.3 per cent before the 1988 Basel Accord to 11.2 per cent in 1996. Moreover, the greatest rises were experienced by those countries whose banks were close to, or below, the Basel minimum standards.23

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  Systemic Risk

  A Practitioner's Guide to Measurement, Management and Analysis

  • Malcolm H.D. Kemp(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The ‘waterfall’ style of approach implicit in such the framework can also be applied to the financial or economic system (with the asset portfolio now con- sisting of multiple firms), or to whole sectors within it, rather than just to individual firms in isolation. 3.3.4 The Structure of Regulatory Frameworks The difference between regulatory minimum Capital Requirements and intrinsic assessments of how much capital is needed by a firm is embedded in the structure of most modern financial sector regulatory frameworks. These tend to adopt a ‘3 Pillar’ approach as illustrated in Fig. 3.2. The exact contents of each Pillar vary a little between different regulatory frame- works but in broad terms: Pillar 1 Minimum Capital Requirements Pillar 2 Supervisory review, governance and own assessment of risk and capital needs Pillar 3 Transparency and market discipline (including reporting) Overall regulatory structure Fig. 3.2 Graphical description of 3 pillar regulatory framework Source: Nematrian 3.3 Regulatory Capital and Economic Capital 71 (1) Pillar 1 involves minimum (regulatory) Capital Requirements. These should make it more likely that regulated financial firms will be able to honour their promises. (2) Pillar 2 includes mechanisms allowing for supervisory review and for establishing appropriate systems of control including effective governance of an organisation. Pillar 2 is usually also deemed to include a (required) own assessment of the risks the organisation faces and hence a required own assessment of the intrinsic capital (and liquidity) needs of the organisation as well as supervisory review of these assessments and gov- ernance systems. This encourages organisations to develop robust risk management disciplines. Implicit is the assumption that firms are likely or ought to have a better understanding than outside parties (including supervisors) of the risks present within their own businesses.

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  The Basel Capital Accords in Developing Countries

  Challenges for Development Finance

  • R. Gottschalk(Author)
  • 2009(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The prevalent view, based on partial equilibrium analysis, suggests that tightening Capital Requirements during recessions provokes a credit crunch to firms, which intensifies the economic downturn. The authors found, amongst other interesting results, that tightening capital require- ments during a recession has a positive impact on households’ savings decisions. Since their savings are the main source of corporate finance, via bank loans, an increase in Capital Requirements ultimately leads to a faster economic recovery . Our approach in this chapter is closer to Benito, Whitley and Young (2001), although our results cannot be directly compared to theirs. We estimate the behaviour of several financial variables, and incorporate the resulting equations into a macroeconometric model. We then simu- late a positive shock in the international and domestic capital adequacy ratios, and analyse its impact on GDP and its components. Our main 100 Ray Barrell and Sylvia Gottschalk results are more comparable to, although they differ significantly from, those of Catalàn and Ganapolski (2005). First, household debt is non- existent in their model. Increases in interest rates translate exclusively into increases in household wealth. Here, household debt incurs inter- est payments that offset the interest paid on savings. Second, in Catalàn and Ganapolski (2005) banks are price-takers. The interest rate that remunerates deposits/savings is determined by the market. The lending rate is modelled as being state-contingent and tied to firm productivity. If the productivity of the firms banks lend to rises, the return on the loans also rises, and banks then increase their loans to firms. In Brazil and Mexico, banks are price-makers and we found that they increase their lending rate when capital adequacy requirements are tightened. Our results show that an increase in capital adequacy ratios has adverse impacts on Brazilian and Mexican GDPs.

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