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Bank Capital
Requirements
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A bank's capital is equal to its assets minus its liabilities. It is the
margin by which its creditors would be covered if assets were
liquidated and its liabilities paid off.
A measure of a bank's financial health is its capital/asset ratio,
which
is required to be above a prescribed minimum.
Requirements
In 1989 the U.S. adopted the
capital requirements
established by the Bank for International Settlements (BIS) in Basel,
Switzerland.
The minimum capital is specified as a percentage of the risk-weighted
assets
of the bank. The following table shows the weight assigned to
each
type of asset.
Asset
|
Risk Weight
|
Cash and equivalents |
0
|
Government securities |
0
|
Interbank loans |
0.2
|
Mortgage loans |
0.5
|
Ordinary loans |
1.0
|
Standby letters of credit |
1.0
|
The BIS rules set requirements on
two categories
of capital, Tier 1 capital and Total capital:
Tier 1 capital is the book value
of its stock
plus retained earnings. Tier 2 capital is loan-loss reserves plus
subordinated debt.** Total capital is the sum of Tier 1 and Tier
2 capital.
Tier 1 capital must be at least 4%
of total risk-weighted
assets. Total capital must be at least 8% of total risk-weighted
assets.
**Subordinated debt is long term debt
that, in case of
insolvency, is paid off only after depositors and other creditors have
been paid. Thus it can be used like equity to provide those
creditors
some protection against insolvency.
An Example
Assume a bank has the following
assets:
Asset
|
Amount
|
Cash and equivalents |
$40m
|
Government securities |
$80m
|
Interbank loans |
$100m
|
Mortgage loans |
$200m
|
Ordinary loans |
$300m
|
Standby letters of credit |
$80m
|
The total risk-weighted assets is
0 x $40m + 0
x $80m + 0.2 x $100m + 0.5 x $200m + 1.0 x $300m + 1.0 x $80m = $500m.
The bank must have Tier
1 capital of at least .04 x $500m = $20m
and Total capital
of at least .08 x $500m = $40m.
Leverage Requirement
In addition to the BIS capital
requirement, the
U.S. imposes a separate leverage requirement on banks. This is
based
on the unweighted sum of all balance sheet assets. Off-balance
sheet
assets such as standby letters of credit are not counted. The
minimum
allowable ratio of Tier 1 capital to total assets is 3%. Bank
regulators
can increase that to as much as 6% depending on the quality of a bank’s
assets. No leverage requirement is specified for total capital.
In the example above, balance
sheet assets total
$720m. Assuming the bank must meet a 4% leverage requirement, it
must hold Tier 1 assets of at least .04 x $720m = $28.8m.
Since that exceeds the $20m BIS Tier 1 capital requirement, the
leverage
requirement governs.
Meeting the New Standards
If a bank is having difficulty
meeting the BIS
capital ratio requirements, there are a number of ways for it to
increase
the ratio. If it is publicly traded, it can issue new stock or
sell
more subordinated debt. However that may be costly if the bank is
in a weak position. Small banks generally do not have the option
of selling new stock since most are not publicly traded.
If the bank cannot increase its
equity, it can
reduce its assets to improve the capital ratio. However shrinking
the balance sheet is not attractive because it hurts
profitability.
Another option is to seek a merger with a stronger bank.
Updating the Requirements
Since the BIS capital adequacy
requirements were
defined and adopted in 1989, banking has become far more complex.
The BIS has been working to better assess the risks in the various
assets
that banks hold. While the basic methodology of limiting a bank's
risk-weighted assets relative to its capital will be retained, more
categories
and revised weightings are now proposed. How soon these revisions
will be universally accepted however is difficult to predict.
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