Bank Regulatory Capital Requirements

Bank regulatory standards have been a work in progress in countries around the world. They have changed several times in recent decades, and most significantly in response to the last banking crisis. They have become ever more stringent and complex for banks of all sizes, but especially for the largest banks. This is certainly the case in the United States. In addition to the legally mandated actions that banking regulators are required to take as a bank's capital declines below specified minimum levels, regulators now subject the larger banks to new comprehensive capital analyses and supervisory stress. Yet, it is not clear whether regulators took appropriate actions in a timely manner to lessen the severity of the most recent banking crisis, nor whether the more extensive analyses and testing contribute to a safer and sounder banking system.

What is clear is that understanding what counts as capital and how capital requirements vary for banks of different asset sizes and business models has become mind-boggling, to say the least. Most importantly, our comparison of various actual capital ratios to the required minimum ratios for a select and important group of banks is quite revealing. The differences found demonstrate the lack of any clear message about whether a bank is or is not adequately capitalized.

Whether banks have too little capital or excess capital depends on the specific required capital ratio on which one focuses and whether the required capital ratio is risk-based or non-risk-based. Some ratios indicate a bank has sufficient capital; other ratios indicate the opposite. Of course, bank supervisors may prefer a regulatory regime with several binding capital ratios, including risk-weighted and unweighted ratios, based on their view that there is no unique ratio that can always help guard against effective risk.

Nonetheless, this situation contributes to confusion, and simply adding more capital requirements is not the way to promote a safer and sounder banking system. Indeed, in 2000, only three different regulatory capital requirements were imposed on banks, two of which were risk-based. However, today there are seven such requirements, six of which are risk-based. These include Tier 1 capital ratio, total capital ratio, leverage ratio (non risk-based), CET1 capital ratio, capital conservation buffer, countercyclical capital buffer, and capital surcharge for GSIBs. While beyond the scope of this review, instead of the existing complexity in the regulatory capital requirements, it may be better to focus to a far greater degree on a simpler, tangible equity leverage ratio as an appropriate capital requirement. This ratio is fairly straightforward and easily understood by market participants. In contrast, too much of a focus on the currently constructed risk-based capital ratios has all too often been misleading with respect to whether banks were adequately capitalized. More generally, financial stability depends on not just an appropriate capital ratio, but other regulatory and supervisory factors that are well beyond the scope of this review.