Bank Regulatory Capital Requirements
Capital Adequacy Standards: Basel Guidelines and Their US Implementation
Basel Capital Adequacy Guidelines
The central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices at the end of 1974 following disruptions in the international financial markets after the breakdown of the Bretton Woods system of managed exchange rates. The committee was later renamed the Basel Committee on Banking Supervision (BCBS). The aim of that committee was and is to promote financial stability by improving banking supervision worldwide. The BCBS seeks to accomplish its aims by establishing minimum standard guidelines for the regulation and supervision of large, internationally active banks. Since its first meeting in February 1975, the BCBS has been meeting regularly three or four times a year. Membership was expanded beyond the G10 in 2009 and again in 2014, so that 28 jurisdictions – 27 countries and the European Union – are now included in the BCBS. BCBS decisions are recommendations, and are thus not legally binding on the member jurisdictions, but the BCBS "expects full implementation of its standards by its member jurisdictions and their internationally active banks".
The Latin American debt crisis of the early 1980s generated concerns about the adequacy of the capital of the large international banks. In response, Congress passed the International Lending Supervision Act of 1983, in part to get US regulators to find a way to raise capital requirements in a multilateral way since differences existed in national capital requirements and concerns existed that these differences would adversely affect banks in the US . Through the BCBS, these efforts culminated in the first Basel Capital Accord (Basel I) in July 1988. Basel I called for a minimum capital ratio, which was based on capital relative to risk-weighted assets (RWAs).
Table 1 offers a summary of the various capital requirements across Basel regimes, which under Basel I, included two tiers of capital, Tier 1 and Tier 2, which combined to form total capital, and these capital measures based on accounting or book values. We list the composition of the different capital concepts are listed in Table 2. Tier 1 capital was initially set at 3.625 percent of RWAs and then increased to 4 percent by the end of 1992, while total capital was increased from 7.25 percent to 8 percent of RWAs over the same period. The BCBS did not recommend a leverage ratio, or non-risk-based capital ratio, at the time.
Table 1. A Timeline of Basel Capital Accords.
| Regulatory Capital Standards | Basel I a(%) | Basel II b(%) | Basel II.5 c(%) | Basel III d (%) | ||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 1993–2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | as of 1 January 2019 | |
| Minimum Tier 1 capital (CET1 plus additional Tier 1) | 4.0 | 4.0 | 4.0 | 4.5 | 5.5 | 6.0 | 6.0 | 6.0 | 6.0 | 6.0 |
| Minimum total capital (Tier 1 plus Tier 2 capital) | 8.0 | 8.0 | 8.0 | 8.0 | 8.0 | 8.0 | 8.0 | 8.0 | 8.0 | 8.0 |
| Common equity leverage ratio e (viewed as a backstop to risk-based ratios) | n/a | supervisory monitoring | test period and disclosure starts 1 January 2015 | 3.0 | 3.0 | |||||
| Minimum CET1 capital ratio | n/a | 2.0 | 2.0 | 3.5 | 4.0 | 4.5 | 4.5 | 4.5 | 4.5 | 4.5 |
| Phase-in of deductions from CET1 (including amounts exceeding the limit for deferred tax assets, mortgage servicing rights, and financials) | n/a | n/a | n/a | n/a | 20 | 40 | 60 | 80 | 100 | 100 |
| Capital conservation buffer | n/a | n/a | n/a | n/a | n/a | n/a | 0.625 | 1.25 | 1.875 | 2.50 |
| Countercyclical capital buffer (discretionary, 0.0% to 2.5%), to be filled with Tier 1 capital | n/a | n/a | n/a | n/a | n/a | n/a | 0.625 | 1.25 | 1.875 | 2.50 |
| Capital surcharge for global systemically important banks | n/a | n/a | n/a | n/a | n/a | n/a | 0.25 to 3.5 | 0.5 to 3.5 | 0.75 to 3.5 | 1 to 3.5 |
| Capital instruments that no longer qualify as noncommon equity Tier 1 capital or Tier 2 capital | n/a | n/a | n/a | 10% per year phase out over 10-year horizon beginning 1 January 2013 f | ||||||
Note: CET1 = common equity Tier 1, n/a = not applicable. a Basel I was finalized in July 1988 and implemented over the period 1988–1992. The figures in the column for Basel I show the final capital standards after implementation. bBasel
II was finalized in June 2004 and implemented over the period 2007–2010. The figures in the column for Basel II show the final capital standards after implementation. c Basel II.5 was finalized in July 2009 and meant to be implemented no later
than 31 December 2011. Basel II.5 enhanced the measurements of risks related to securitization and trading book exposures. d Basel III was finalized in December 2010 and meant to be implemented over the period 2013–2018. eThe leverage
ratio is calculated as the ratio of Tier 1 capital to balance-sheet exposures plus certain off-balance-sheet exposures. f The phasing works by capping the amount that can be included in capital from 90 percent on 1 January 2013, and reducing
this cap by 10 percent in each subsequent year.
Table 2. Components of Total Capital.
| Tier 1 capital | At least 50 percent of a bank's capital base to consist of a core element comprised of equity capital and published reserves from post-tax retained earnings minus goodwill |
| Tier 2 capital | Undisclosed reserves, asset revaluation reserves, general provisions/general loan-loss reserves, hybrid (debt/equity) capital instruments and subordinated debt, and limited to a maximum of 100 percent of the total of Tier 1 elements |
Note: Tier 1 capital did not include goodwill, which is the present value of conjectural future profits arising from an acquisition when the amount paid is in excess of the target firm's value, because its ability to absorb losses is unclear. Goodwill shows up on the balance sheet, but is recognized as not being easily converted into cash.
However, the BCBS intended these capital ratios to evolve over time as events unfolded and new information became available. In January 1996, for example, the BCBS issued guidelines within Basel I to incorporate market risks in capital requirements, since initially only credit risks were addressed. This new capital requirement took into account the risk of losses in on-balance-sheet and off-balance-sheet positions arising from movements in market prices. At the same time, a third kind of regulatory capital, Tier 3, became part of total capital . These changes were to take effect at the end of 1997 and allowed banks, for the first time, to use internal models (value-at-risk models) as a basis for calculating their market-risk capital requirements.
In June 2004, the BCBS replaced the Basel Capital Accord (Basel I) with the Revised Capital Framework (Basel II). Basel II was made up of three pillars: Pillar I, which was designed to develop and expand the minimum capital requirements in Basel I; Pillar II, which provided for supervisory review of a bank's capital adequacy and internal assessment process; and, Pillar III, which called for the effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices. The minimum required risk-based capital ratios for Tier 1 and total capital were left unchanged at 4 percent and 8 percent, respectively, as shown in Table 1. The BCBS member countries and several non-member countries agreed to adopt the new guidelines, but on varying national timescales.
The BCBS agreed to Basel II.5 in July 2009 as a revision of Basel II, which BCBS members believed had failed to properly address market risk that banks took on their trading books. Basel II.5 introduced an incremental risk charge (IRC) to estimate and capture default and credit migration risk (i.e., the risk when customers move their loans from one bank to another bank). Basel II.5 also introduced an additional charge to compensate for an increase in one risk that leads to an increase in another risk (i.e., correlated risk). In addition, BCBS introduced stressed value-at-risk to require banks to calculate capital requirements under stress conditions. Lastly, standardized charges were introduced for securitization and re-securitization positions.
The BCBS issued Basel III in December 2010 and revised it in June 2011, after the global banking crisis. BCBS made the revisions to enhance the Basel framework and strengthen the three pillars that were established by Basel II. The new framework (Basel III) also introduced several regulatory capital innovations. Basel III established new minimum common equity and Tier 1 requirements and added an additional layer of common equity (the capital conservation buffer), a countercyclical buffer, a leverage ratio (based on both a bank's on-balance-sheet assets and off-balance-sheet exposures regardless of risk weighting), and supplementary capital requirements for systemically important banks. Also introduced were a liquidity coverage ratio (intended to provide enough cash to cover funding needs over a 30-day period of stress) to be phased in from 1 January 2015, to 1 January 2019, and a longer-term net stable funding ratio (intended to address maturity mismatches over the entire balance sheet) to take effect as a minimum standard by 1 January 2018.
The final capital standards introduced by Basel III were to be phased in over time, as shown in Table 1. The recommended leverage standard will be 3 percent in 2019. The recommended Tier 1 risk-based capital standard will be 6 percent and the total risk-based capital standard will be 8 percent. If one adds the capital conservation and countercyclical capital buffers to the total capital standard, the capital ratio can be as high as 13 percent for some banks, and even as high as 16.5 percent if one adds a capital surcharge of 3.5 percent for global systemically important banks (GSIBs).
The Financial Stability Board (FSB), which makes policy recommendations to G20 members, has proposed further increasing requirements on GSIBs through a total loss-absorbing capacity (TLAC) requirement. On top of the required minimum common equity Tier 1 (CET1) ratio of 4.5 percent, GSIBs would have to fund with an additional 11.5 percent of "loss absorbency" in the form of Tier 1 and Tier 2 capital relative to risk-weighted assets. This requirement would rise to 13.5 percent by 2022. The FSB expects GSIBs to meet this requirement in part through long-term, unsecured debt, which can be converted into equity when a bank fails. The emphasis on convertible debt is meant to put an end to "too big to fail" by forcing bondholders rather than taxpayers to inject capital into a large bank that fails.