Regulatory Capital

Published on :

21 Aug, 2024

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Regulatory Capital is the amount of liquid funds or cash that a bank has to keep aside and maintain at all times. It is a mandatory requirement enforced by the bank's regulator. Liquid funds are easily sellable securities or assets, and it is a standard regulation that applies to banks, depository institutions, and other financial bodies.

The main objective of maintaining this capital is to prevent banks from over-investing in the financial market. Also, it ensures that the holdings are sufficient compared to the overall investment to mitigate the bank's risk exposure to defaults. The regulation is a standard protocol devised by several regulatory agencies, such as the Federal Reserve Board, the Bank for International Settlements (BIS), and the Federal Deposit Insurance Corporation (FDIC).

What Is Regulatory Capital?

Regulatory capital is a requirement of a banking and financial institution to maintain a particular amount of liquid funds at all times, enforced by their regulator.
Several regulatory bodies, such as the Federal Deposit Insurance Corporation, the Bank for International Settlements, and the Federal Reserve Board, set these regulations.
As per the Basel Committee on Banking Regulation and Supervisory Practices for all internationally active commercial banks, the capital requirement is 8% of total assets.
It is an ever-evolving regulation. Global financial authorities and regulators may change in the future, either in response to identified needs or to align with shifts in the world’s financial stability and market factors.

Regulatory Capital Explained

Regulatory capital is the minimum amount a bank must keep aside in the form of liquid funds. In case of any major requirement, crisis, or potential risk, the money can be used to survive, and the banks remain solvent. Every country has an official banking sector regulatory body that is responsible for creating policies and enforcing laws and regulations. All the commercial and public sector banks are answerable to it.

Before the 1980s, there were no such regulatory capital requirements on banks. Still, it was often seen as one of the many evaluation factors when Mexico declared that it would default on interest payments on its national debt in 1982. The world authorities noticed the issue, and the collective initiative led to legislation called the International Lending Supervision Act of 1983.

Following the 1982 default by Mexico, the Basel Committee on Banking Regulation and Supervisory Practices took significant steps in 1988 to address banking stability. They declared that for all internationally active commercial banks, the capital requirement would be increased from 5.5% to 8% of total assets. Under the current regulatory capital value guidelines, US banking entities must satisfy a certain minimum capital-to-risk weighted asset ratio and capital-to-total assets ratio.

These guidelines aim to strike a balance: preventing investments from dominating the bank's holdings while ensuring sufficient capital to sustain operating losses. In the US, this capital depends on multiple aspects, but primarily, it focuses on assuring that the entire financial system is safe and running efficiently.

Examples

Below are two examples for better understanding.

Example #1

Let us consider XYZ Bank, which is overseen by a government-assigned regulatory body. The bank is active in all operations and daily activities like withdrawals, deposits, issuing loans, offering credit cards, and so on. Additionally, it makes market investments and has many assets.

The bank regulator has made it compulsory for XYZ Bank to have $9 million in liquid assets that can easily be turned into cash. With this guideline, the regulator ensures that the bank is not overinvesting and has the right amount of funds ready in case of a crisis. It is a straightforward example of this kind of capital. However, in real-world banking, there are regulatory capital ratios, along with many direct and indirect factors.

Example #2

On 27 July 2023, the US federal banking regulators issued a revised capital proposal for some new risk-based regulatory capital requirements. These requirements specifically target midsize and larger US banking organizations. Specifically, the proposal applies to banking organizations with $100 billion or more in assets. Additionally, the capital proposal makes substantial changes to the risk-based regulatory capital calculations and expands the risk range of the capital held.

Some key changes include replacing advanced approaches for credit risk and mandating banks to calculate their risk-based capital ratios under both the existing and expanded standardized approach. Additionally, the proposal shifts the model-based approach for operational risk with a standardized framework.

Advantages And Disadvantages

Its advantages are as follows:

It sets an industry standard for every bank and financial institution to follow and adhere to.
It is important to keep liquid funds in a minimum amount to be prepared for any potential market or banking crisis.
Sometimes, these funds are used to support daily banking operations in case there are heavy transactions.
Through this rule, the bank regulators ascertain that the bank is following the guidelines and is not making over-limit investments.

Its disadvantages are listed below:

It restricts banks and financial institutions to invest over a certain limit.
Compliance with these requirements raises many functional costs for banks and consumers.
It minimizes the bank's credit availability and loans.

Regulatory Capital vs Economic Capital

The main differences between regulatory and economic capital are as follows:

Aspect	Regulatory Capital	Economic Capital
Definition	The minimum amount of money a bank must maintain in liquid funds.	It is used to assess risk and cover the economic effects of any new project, operation, or risk-bearing activity.
Purpose	It is mandated by bank regulators to ensure not all money is used in market investments.	Economic capital is seen as a tool for performance assessment and capital allocation.
Primary stakeholders	Primary stakeholders become the bank's depositors.	Shareholders remain the primary stakeholders.
Objective	Its objective is to minimize the possibility of loss and support active operations.	The goal of economic capital is wealth maximization.

Frequently Asked Questions (FAQs)

Is regulatory capital tier 1 capital?

Yes, it includes Tier 1 capital. As per the Federal Deposit Insurance Act, banks must have at least a 4.5% tier 1 capital to risk-weighted assets ratio. Banks hold tier 1 capital, the core capital, and is actively used to fund and support the business activities for the bank's customers, clients, and other operational tasks. It technically includes disclosed reserves, common stock, certain preferred stocks, and retained earnings.

What are the tiers of regulatory capital?

A bank's capital is made up of tier 1 and tier 2 capital. These are the primary types of reserves a bank holds. Tier 1 is the bank's core capital, while tier 2 capital signifies supplementary capital such as hybrid financial products, subordinated term debts, and undisclosed reserves. The total available capital is the sum of these two elements, which form the backbone of a bank's financial reserves.

What is the regulatory capital risk?

It defines the capital adequacy of deposit takers. The ratio of the total regulatory capital and the risk-weighted assets ratio measures the regulatory capital risk. This ratio helps in evaluating banks and comparing multiple financial institutions based on their capital adequacy and risk assessment.