Bank Regulatory Capital Requirements

Introduction

Banks are vital in facilitating the exchange of goods and services by providing a payment system and channeling savings to productive investment projects that foster economic activity. However, banking crises have historically contributed to declines in overall economic activity. Furthermore, the ensuing policy response to crises often calls for implementing a variety of banking reforms that may be ineffective or even undermine existing policies.

Capital requirements can be an important tool that bank regulators use to promote a well-functioning banking system, presuming that sufficient levels of owner-contributed equity capital improve a bank's ability to withstand large shocks to asset values. These requirements have grown increasingly complexity in recent decades. Fully understanding their nuances presents a challenge, even for those who have spent substantial time studying them. Further adding to the challenge is the existence of multiple capital requirements that are satisfied by different items.

This review of bank capital regulation discusses the growing complexity of Basel capital adequacy guidelines, which, when implemented by a country's regulators, pose a challenge for bank regulatory compliance, oversight, and academic and policy analysis. As evidence of that growing complexity we show that regulatory capital requirements can generate up to 25 percent of all regulatory restrictions and on average thousands of additional words embodied in the parts of the United States (US) Code of Federal Regulations (CFR) that concern banks.

We also show that despite the increased complexity of the regulatory capital ratios, they do not provide equally valuable information about whether a bank is adequately capitalized. The data presented clearly indicate that whether banks have too little capital or excess capital depends on the specific capital ratio on which one focuses and whether the capital ratio is based on the riskiness of a bank's business model. Some ratios may indicate that a bank has sufficient capital while other ratios indicate the opposite. A higher regulatory capital ratio that is imposed on banks may or may not affect bank behavior. The specific ratio that regulators choose to increase is crucial. In the aggregate, the market knows that not all ratios are equally revealing about a bank's actual capital adequacy, and thus some ratios receive more attention than others. Given this situation, emphasis could be placed on a straightforward and easily understood capital ratio that market participants have always paid attention to when they assess whether a bank is adequately capitalized. Indeed, some recent studies show that the benefits outweigh the costs.

The remainder of the paper proceeds, as follows. The next section summarizes the Basel Capital Accords and their US implementation. Section 3 discusses additional regulatory measures that US regulators apply, including Prompt and Corrective Action (PCA), comprehensive capital analyses, and supervisory stress testing to which regulators now subject the larger banks. PCA describes the actions that banking regulators are legally required to take as a bank's capital declines below specified minimum levels. This is important because, based on publicly available information, researchers are able to determine whether the regulatory authorities actually take the actions that are required when banks encounter financial difficulties. Section 4 explains that the new capital requirements have generated considerable controversy because they require banks to hire more employees with quantitative skills, which results in an increase in costs without a corresponding increase in revenues. It is not clear, moreover, whether the more extensive analyses and testing contribute to a safer and sounder banking system. Section 5 concludes with a suggestion for greater emphasis on a minimum required capital ratio that eliminates most of the confusion over determining whether a bank is adequately capitalized – one that market participants themselves relied on during the most recent banking crisis of 2007–2009.