The role of capital requirements in ensuring capital adequacy

Hausarbeit, 2016

11 Seiten


1 Introduction

2 Capital adequacy and capital requirements

3 The Basel frameworks and the components of capital

4 The role and consequences of capital requirements

5 Conclusion

6 References

1 Introduction

In this paper, the impact of higher capital requirements to the capital adequacy of banks as well as its consequences to the financial system will be discussed. Therefore, these terms will be explained and an overview of the developed guidelines will be given. With the help of that knowledge, the actual challenges for financial institutions can be set in relation to these rules in order to find an appropriate level of banking regulation. This topic has a special meaning to society, because the banking sector is highly leveraged and can cause great economic damage if there is a lack of sufficient risk management (Fatima 2014, pp. 771f.).

2 Capital adequacy and capital requirements

Our thesis sets the term ‘capital adequacy’ as a valuable goal of regulation efforts, so it should be defined clearly: It is ‘a measure of a bank's or other financial institution's ability to pay its debts if people or organizations are unable to pay back the money they have borrowed from the bank’ (Cambridge 2016). This can also be expressed as a ‘percentage ratio of a financial institution's primary capital to its assets (loans and investments), used as a measure of its financial strength and stability’ (BusinessDictionary 2016). So if we assume a proper capital adequacy, we can speak of a healthy bank or banking system, obviously with enough equity to pay for present and future obligations, even for the unforeseen ones. Interestingly, it is used as a ratio for itself, so its meaning could be overlapping with our second term ‘capital requirements’, which is sometimes used synonymously and refers to the minimum capital for banks demanded by the Basel regulations. They are both also called capital adequacy requirements (Caruana/Narain 2008, p. 24). Reformulated, our working thesis reads as follows: Higher public capital requirements are necessary to maintain and develop a strong, liquid and less vulnerable financial system with lower banking default risks and subsequently higher prosperity.

3 The Basel frameworks and the components of capital

The first global standard for capital requirements was the introduction of Basel I in 1988 which set a relation of risk-weighted assets (RWA) to banks’ equity capital with the aim of preserving system stability (Zaher 2007). That means that with increasing asset risk, which was categorized in the four different classes pictured in figure 1, more capital was required. Before that, the quality of diverse assets was not regarded by regulators.

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Figure 1: Basel I risk weights, 2016

Furthermore, a minimum total capital requirement of 8% of RWA was implemented and additionally off-balance sheet items, e.g. guarantees or swap exposures, were included (Koch/MacDonald 2015, pp. 450ff.). This requirement is expressed as the capital adequacy ratio (CAR), whose application has the aim to prevent insolvency as well as to ensure the ability of growth (Fatima 2014, p. 773) and which is shown in the formula below:

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Figure 2: Capital adequacy ratio, source: Investopedia 2016

As can be seen in the numerator, there are two relevant tiers of capital. Tier 1, or core capital, describes basically the common stockholders’ equity capital, adjusted by goodwill, deferred taxes and unrealized holding gains. Further important is, that there is a minimum Tier 1 to RWA requirement of 4% in the Basel I framework. Tier 2 capital, which is limited to the amount of Tier 1, is also called supplementary capital and is composed of different types of preferred stock and subordinated debt (Koch/MacDonald 2015, pp. 459ff.).

That first standardized approach of measuring asset risk was revised with the Basel II accord starting in 2006. The capital adequacy requirements were partly improved and adjusted to the real individual risks in banks’ balance sheets. In the so called ‘first pillar’ there was a distinction of different risk measurement methods, reaching from the simplified Basel I RWA method to the usage of external agency as well as bank-internal ratings. With a concrete calculation of default probabilities, e.g. via internal stress tests, risk weights were shifting and capital requirements could subsequently change noticeably (IMF 2005). A second innovation was the inclusion of operational risks, e.g. catastrophes, failed processes, damaged facilities, cybersecurity threats or reputation losses, into the capital adequacy rules (Koch/MacDonald 2015, pp. 111f.). To buffer unforeseen capital declines there was established a supervisory review in the second pillar of Basel II. If Banks’ internal processes weren’t sufficient, the authorities could increase capital requirements (IMF 2005).

The main goal of the Basel III rules is to improve the quality and consistency of the capital adequacy ratios by enhancing the convergence of the term ‘capital’ in the numerator of the ratios (Arnold 2012). Particularly after the 2008 financial crisis the capital requirements for banks should be stronger and regulators set common equity as the preferred form of capital. Therefore, the new capital ratio ‘common equity Tier 1’ (CET1), which consists of a minimum requirement and a buffer, was introduced (Koch/MacDonald 2015, p. 462). Furthermore, the risk-weighting for some types of assets were altered, so that additional capital is needed (Ibid., p. 480). In 2019, when the adequacy rules are fully phased in, the following requirements are necessary:

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Figure 3: Regulatory capital under Basel III, source: Harper 2015

If the capital conservation buffer of 2.5% of RWA is not or only partly reached, the bank is forced to retain earnings as well as dividends to some extent and executive bonus payouts are limited until the requirement is met (Harper 2015).


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The role of capital requirements in ensuring capital adequacy
School of Oriental and African Studies, University of London
Bank Financial Management
ISBN (eBook)
ISBN (Buch)
439 KB
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Arno Hetzel (Autor), 2016, The role of capital requirements in ensuring capital adequacy, München, GRIN Verlag,


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