Bank Regulatory Capital Requirements

While the US has for the most part adopted Basel guidelines, important differences exist, and Table 3 shows how the US implementation has varied according to Basel I, Basel II, Basel II.5, and Basel III. One important difference between the Basel guidelines and the US implementation has been that, unlike the former, the latter has included a leverage capital requirement in addition to the risk-based capital requirements. In addition, the US implementation applies to every bank, although some differences exist based on the bank's asset size. The risk-based capital requirements provide an incentive for banks to focus more on assets with lower risk weights, which can lead banks to change their business models.

Table 3. A Timeline of United States (US) Capital Requirements.

Note: AA = advanced approaches, CET1 = common equity Tier 1, GSIB = global systemically important bank, IDI = insured depository institution, n/a = not applicable, NAA = non-advanced approaches. ^a Basel I was finalized in July 1988 and phased in over the period 1988–1992; it became fully effective in 1992 for all US banks. For the 1988–2010 period, see Federal Register 1989. ^b US banking regulators published a final Basel II rule in December 2007 with a phase-in and it did not become effective until 1 April 2008. See Federal Register 2007. US federal banking agencies chose not to apply Basel II to all US banks, but only to the very largest, internationally active "core" US banks. ^c US banking regulators published the final rule in June 2012 that became effective 1 January 2013, with revisions to certain capital requirements for trading positions and securitizations. See Federal Register 2012d. ^d US banking regulators issued a final rule in July 2013 implementing Basel III; the rule became effective for AA banks, those with more than $250 billion in assets or more than $10 billion of on-balance-sheet foreign exposures, on 1 January 2014, and for NAA banks on 1 January 2015. See Federal Register 2013. The Collins Floor, required by the Dodd-Frank Act, established a firm's minimum capital ratio as the lower of its standardized-approach and advanced-approaches ratios, which include both minimum capital standards and the capital conservation buffer. ^e The Tier 1 leverage ratio is the ratio of Tier 1 capital to on-balance-sheet assets less items deducted from Tier 1 capital. The leverage ratio applies to all banks, and must be at least 4 percent for an institution to be adequately capitalized and 5 percent to be well capitalized. The supplementary leverage ratio only applies to AA banks and is the ratio of Tier 1 capital to both on-balance-sheet and selected off-balance-sheet assets, or leverage exposure. ^f Leverage ratio for AA bank holding companies is based on both on-balance-sheet and off-balance-sheet items, while only on-balance-sheet items are included for NAA bank holding companies. ^g A bank's capital conservation buffer of 2.5 percent (on top of each risk-based ratio) will equal the lowest of the following three amounts: (1) a bank's CET1 ratio minus 4.5 percent; (2) a bank's Tier 1 risk-based capital ratio minus 6 percent; (3) a bank's total risk-based capital ratio minus 8 percent. Failure to meet these requirements results in restrictions on payouts of capital distributions and discretionary bonus payments to executives. ^h GSIBs calculate their surcharges using two methods and use the higher of the two surcharges. The first method is based on the framework agreed to by the Basel Committee on Banking Supervision and considers a GSIB's size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity. The second method uses similar inputs, but is calibrated to result in significantly higher surcharges and replaces substitutability with a measure of the firm's reliance on short-term wholesale funding. ⁱ Basel III revised the regulatory capital treatment for Trust Securities, requiring them to be partially transitioned from Tier 1 capital into Tier 2 capital in 2014 and 2015, until fully excluded from Tier 1 capital in 2016, and partially transitioned and excluded from Tier 2 capital beginning in 2016. The exclusion from Tier 2 capital starts at 40 percent on January 1, 2016, increasing 10 percent each year until the full amount is excluded from Tier 2 capital beginning on 1 January 2022.

Like Table 1, Table 3 reveals the growing complexity of regulatory capital requirements since Basel I, especially after US banking regulators issued the final rule regarding the Basel III implementation in July 2013. Basel III regulation intends to strengthen the definition of regulatory capital, increase the minimum risk-based capital requirements for all banks, and modify the requirements for how banks calculate risk-weighted assets. It also retains the generally applicable leverage ratio requirement that banking regulators believe to be a simple and transparent measure of capital adequacy that is credible to market participants and ensures that a meaningful amount of capital is available to absorb losses. It includes both "advanced approaches" for determining the risk weight of assets for the largest internationally active banking organizations and a standardized approach that will apply to all banking organizations, except small bank holding companies (BHCs) with less than $500 million in assets. Basel III regulation became effective for advanced-approaches banks on 1 January 2014, and on 1 January 2015 for non-advanced-approaches banks. Also, advanced-approaches banks have to calculate standardized-approach RWAs in addition to advanced-approaches RWAs for purposes of applying the "Collins Floor", which establishes a bank's minimum capital ratios as the lower of its standardized-approach and advanced-approaches ratios.

Under Basel III, there are several new and more stringent capital requirements, as well as different capital requirements for banks of different sizes and systemic importance. In particular, there is a new CET1 capital ratio set at 4.5 percent of risk-based assets. The Tier 1 capital ratio is set at 6 percent (an increase from 4 percent), while the total capital ratio remains at 8 percent. The capital requirements are more stringent for the advanced-approaches banks and a subset of those banks identified as GSIBs. Indeed, for GSIBs the sum of the minimum total capital, the capital conservation buffer, the countercyclical capital buffer, and the GSIB surcharge can be as high as 17.5 percent of risk-based assets. The Federal Reserve Board (FRB) in July 2015 established the methods that US GSIBs will use to calculate a risk-based capital surcharge, which is calibrated to each firm's overall systemic risk. In particular, the GSIBs are required to calculate their surcharges under two methods and use the higher of the two. The first method is based on the framework that was agreed to by BCBS and considers a GSIB's size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity. The second method uses similar inputs, but it is calibrated to result in significantly higher surcharges and replaces substitutability with a measure of the bank's reliance on short-term wholesale funding. The surcharges are being phased in – implementation began on 1 January 2016, and it will become fully effective on 1 January 2019.

Table 4 provides information on the various components of regulatory capital that are associated with the different required capital ratios under the US implementation of the Basel Capital Adequacy Standards. Different countries were free to implement the Basel Capital Adequacy Standards as they saw fit, given that Basel III provided guidelines rather than strict rules for the bank regulatory authorities in those countries implementing it. In the US, Basel III implementation brought major changes in the components of capital. In particular, banking regulators now consider the new capital measure, CET1 capital, to be the most loss-absorbing form of capital. The new emphasis on CET1 no doubt reflects the fact that, as the banking crisis emerged, market participants chose to focus more on capital measures that reflected loss-absorbing capital than on the official regulatory measures. CET1 includes qualifying common stock, retained earnings, certain accumulated other comprehensive income (AOCI) elements (if the bank does not make an AOCI opt-out election) plus or minus regulatory deductions or adjustments as appropriate, and qualifying CET1 minority interests. The banking regulators expect the majority of CET1 capital to be in the form of common voting shares. Non-advanced-approaches banks were allowed on their 31 March 2015 Call Report to make a permanent, onetime opt-out election, enabling them to calculate regulatory capital without AOCI. Such an election neutralizes the impact of unrealized gains or losses on available-for-sale bond portfolios in the context of regulatory capital levels. For banks that did not opt out, the AOCI adjustment to CET1 capital could have a significant impact on regulatory capital ratios if significant bond portfolio appreciation or depreciation occurs.

Table 4. A Timeline of US Regulatory Capital Components.

Note: CET1 = common equity Tier 1, DTA = deferred tax assets, MSR = mortgage servicing rights, n/a = not applicable, PCCR = purchased credit card receivables, SBLF = small business lending fund, TARP = troubled asset relief program. ^a See Federal Register 1989. ^b See Federal Register 2007. ^c See Federal Register 2012d. ^d See Federal Register 2013. ^e For the rule introducing Tier 3 capital, see Federal Register 1996.

Unfortunately, this is not the end of the story. Fully describing what counts as regulatory capital demonstrates the complexity that is associated with calculating capital that complies with the regulatory requirements. Highlighting this complexity also reveals the difficulties that researchers must confront when they assess how changes in capital requirements affect bank behavior. For example, banks may respond differently to capital requirements depending on differences in both the level of existing capital and the composition of the existing components of that capital.

Banks must fully deduct several items from CET1 capital, such as goodwill, deferred tax assets that arise from a net operating loss and tax credit carry-forwards, other intangible assets (except for mortgage servicing assets), gains on sale of securitization exposures, and certain investments in another financial institution's capital instruments. Banks also must consider threshold deductions for three specific types of assets: mortgage servicing assets, deferred tax assets that are related to temporary timing differences, and significant investments in another unconsolidated financial institution's common stock. Generally, banks must deduct, by category, the amount of exposure to these types of assets that exceeds 10 percent of a base CET1 capital calculation. In addition, there is a 15 percent aggregate limit on these three threshold deduction items in CET1.

Additional non-CET1 capital includes qualifying noncumulative perpetual preferred stock, bank-issued Small Business Lending Fund and Troubled Asset Relief Program instruments that previously qualified for Tier 1 capital, and qualifying Tier 1 minority interests, less certain investments in other unconsolidated financial institutions' instruments that would otherwise qualify as additional Tier 1 capital. Tier 2 capital includes the allowance for loan and lease losses up to 1.25 percent of risk-weighted assets, qualifying preferred stock, subordinated debt, and qualifying Tier 2 minority interests, less any deductions in the Tier 2 instruments of an unconsolidated financial institution. Previous limits on term subordinated debt, limited-life preferred stock, and the amount of Tier 2 capital that can be included in total capital no longer apply. Non-qualifying capital instruments issued before 9 May 2010, by banks with less than $15 billion in assets (as of 31 December 2009) are grandfathered, with the exception that grandfathered capital instruments cannot exceed 25 percent of Tier 1 capital.

In assessing the financial condition of a bank, the denominator in the risk-based capital ratio is as important as the numerator, if not more so. As noted earlier, Basel I was the first capital standard based on RWAs. Then, in response to the growing importance of trading activities of large banks, Basel I was amended in 1996 to expand capital requirements to include capital charges for market risk. Then again, Basel II.5 added capital charges for certain types of trading activities by changing the calculation of risk weights for the trading book. More generally, as compared to Basel I, Basel II and II.5 provided for more detailed calculations of the risk-sensitivity of banks. Indeed, according to Andrew Haldane, "[For] a large, representative bank using an advanced internal set of models to calibrate capital… [its] number of risk buckets has increased from around seven under Basel I to, on a conservative estimate, over 200,000 under Basel II".

In Basel III, there are two general approaches to RWAs. The standardized approach is generally designed for community banks, while the advanced approach is used by larger, more complex banks. The standardized approach applies to BHCs with $500 million or more in consolidated assets. Risk-weighted assets consist of credit-risk RWAs plus market-risk RWAs (if applicable). Credit-risk RWAs include risk-weighted assets for general credit risk, cleared transactions, default fund contributions, unsettled transactions, securitization exposures, and equity exposures. General credit risk involves the consideration of general risk weights, off-balance-sheet exposures, over-the-counter derivative contracts, cleared transactions, guarantees, credit derivatives, and collateralized transactions. Since the introduction of the risk-weighting system in the United States in the early 1990s, the general process of risk weighting assets has not changed. However, the movement from Basel I to Basel III has brought several specific changes in risk weights.

Table 5 shows that the standardized approach for Basel III involves risk weights other than the 0, 20, 50, and 100 percent categories that were initially implemented for Basel I. The Basel III risk-weighting categories allow for more detailed risk weights, and the weights now range from a low of 0 to a high of 150 percent. The risk weight for exposures to, and portions of exposures that are directly and unconditionally guaranteed by, the US government, its agencies, and the Federal Reserve is zero percent. The risk weight for high-volatility commercial real estate loans is 150 percent, up from 100 percent under Basel I. Section 939 of the Dodd-Frank Act directs the banking regulators to remove regulatory references to external credit ratings from regulations. This provision was a legislative response to the failure of the ratings to adequately indicate the riskiness of various securities. That failure affected the ability to assess the riskiness of banks and other entities leading up to the 2007–2009 financial crisis.

Table 5. Basel I and Basel III: US Risk Weights for On-Balance-Sheet and Off-Balance-Sheet Items for the Standardized Approach.

^a See Federal Register 1989. ^b See Federal Register 2013. Additional source: Davis Polk, U.S. Basel III Final Rule: Standardized Risk Weights Tool.

The advanced approach under Basel III applies to BHCs with consolidated assets that are greater than $250 billion or balance-sheet foreign exposures greater than $10 billion. These banks are required to determine compliance with minimum capital requirements based on the lower of the capital ratios that were calculated under the standardized and advanced approaches. Using the advanced approach, risk-weighted assets are the sum of credit-risk RWAs, market-risk RWAs (if applicable), and operational RWAs. Credit-risk RWAs include risk-weighted assets for general credit risk, securitization exposures, and equity exposures. General credit risk refers to wholesale and retail RWAs, as well as the counterparty credit risk of repo-style transactions, eligible margin loans, over-the-counter derivative contracts, cleared transactions, unsettled transactions, guarantees, and credit derivatives. Market-risk RWAs – which apply only to BHCs that have aggregate trading assets and liabilities equal to either 10 percent or more of total assets or at least $1 billion – are based on the following risk categories: interest rate, credit spread, equity price, foreign exchange, and commodity price. Operational-risk RWAs have the same basic RWA formula as that of market risk.