Capital and Liquidity Requirements

Overview

Capital requirements are the standardized measure in place for banks and other depository institutions that determines how much liquidity is required to be held for a certain level of assets. These requirements are set by regulatory agencies, such as the bank for International Settlements, the Federal Reserve Board, and the Federal deposit Insurance Company.

These requirements are set to ensure that banks and depository institutions are not holding investments that increase the risk of default. They also ensure that banks and depository institutions have enough capital to sustain operating while still honoring withdrawals. A capital requirement is also known as regulatory capital.

In the U.S., the capital requirement for banks is based on several factors, but is mainly focused on the weighted risk associated with each type of asset held by the bank. The capital requirements guidelines are used to create capital ratios, which can then be used to evaluate and compare lending institutions based on their relative strength and safety. An adequately capitalized institution, based on the Federal Deposit Insurance Act, must have a Tier 1 capital-to-risk weighted assets ratio of at least 4%. Institutions with a ratio below 4% are considered undercapitalized, and those below 3% are significantly undercapitalized.

Regulation

The aftermath of the financial crisis has been punctuated by calls for financial reform to ensure that it will never happen again. Among the myriad proposed reforms are calls for increasing capital requirements. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandates that U.S. regulators increase capital requirements for financial companies deemed to be systemic.

The Basel III international capital standards proposed by the Basel Committee on Banking Supervision will require all banks to hold more capital; they also impose a capital surcharge on systemic firms. U.S. and European banking supervisors regularly assess the capital adequacy of their large systemic banking companies through a series of “stress tests.” Overall, the objective of the new emphasis on capital requirements as a regulatory tool is to increase the resiliency of individual financial firms and thereby financial markets.

Another part of the regulatory landscape are the addition of liquidity requirements, which are mandated for U.S. banks in the Dodd–Frank Act and will be a component of the Basel III capital accords

Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework on bank capital adequacy, and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again extended to 31 March 2019.

The U.S. Federal Reserve plans to implement substantially all of the Basel III rules and has made clear they will apply not only to banks but also to all institutions with more than US$50 billion in assets:

  • "Risk-based capital and leverage requirements" including annual, conduct stress tests and capital adequacy.
  • Market liquidity that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime.
  • The Federal Reserve Board would conduct tests annually "using three economic and financial market scenarios". Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information, would be made public" but one or more internal company-run stress tests must be run each year with summaries published.
  • Singe-counterparty credit limits to cut credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit".
  • Early remediation requirements to ensure that financial weaknesses are addressed at an early stage.

 

 

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