What is bank capital and what are the levels or tiers of capital?
Bank capital serves as an important cushion against unexpected losses.
It creates a strong incentive to manage a bank in a prudent manner, because
the bank owners' equity is at risk in the event of a failure.
Thus, bank capital plays a critical role in the safety and soundness of
individual banks and the banking system.
Bank capital is often defined in tiers or categories that include shareholders'
equity, retained earnings, reserves, hybrid capital instruments, and subordinated
term debt. Capital ratios are commonly measured as a percent of bank assets
or risk-weighted bank assets. The chart below plots the behavior of two
measures of U.S. commercial bank capital ratios over recent years.
Current Capital Requirements
The Basel Committee on Banking Supervision's 1988 Capital Accord (Accord)
sets capital requirements for major international banks from the G10 countries.
The Accord became the model for risk-based capital standards for the U.S.
the following year.
The Accord requires international banks to
hold capital equal to at least 8% of a basket of assets
measured in different ways according to their riskiness."
Under the Accord, the riskier a bank's portfolio, the more capital it
would be required to hold.
The minimum 8 percent capital requirement for each bank may be met by
holding two categories of capital, although at least half of a bank's
capital must be Tier 1 capital.
- Tier 1 Capital is calculated as follows:
+ Permanent shareholders' equity
+ Disclosed reserves (including retained earnings)
- Tier 2 Capital is calculated as follows:
+ General provisions/general loan-loss reserves
+ Revaluation reserves
+ Hybrid (debt/equity) capital instruments
+ Subordinated term debt
+ Undisclosed reserves (not allowed for U.S. banks)
Less: Investments in unconsolidated financial subsidiaries
Less: Investments in the capital of other financial institutions
- Total Capital = Tier 1 Capital + Tier 2 Capital
These categories of capital are then divided by the sum of a bank's risk-based
assets to generate the appropriate risk-based capital ratios. The example
below shows the risk-based capital ratios for the U.S. banking system.
The Accord created policy guidelines that each nation's banking supervisors
can follow to enhance the safety and soundness of the international banks
they supervise. The Accord was designed to align regulatory capital requirements
across nations-to "ensure an adequate level of capital in the international
banking system," and to create a "more level playing field,"
A New Accord: BASEL II
Basel II, a new, more flexible, and risk-sensitive set of capital standards,
has been proposed for final implementation at yearend 2006. The proposed
standards will address some of the weaknesses of the 1988 Accord by creating
a more risk-sensitive framework and improving risk measurement and management
capabilities. For additional information, see the Basel Committee on Banking
Supervision's website at: http://www.bis.org/publ/bcbsca.htm