A capital requirement is the standardized requirement in place for banks and other depository institutions that determines how much liquidity is required to be held for a certain level of assets.
BREAKING DOWN ‘Capital Requirement’
These requirements are set to ensure that banks and depository institutions are not holding investments that increase the risk of default. They also ensure that banks and depository institutions have enough capital to sustain operating losses while still honoring withdrawals. A capital requirement is also known as regulatory capital.
In the United States, the capital requirement for banks is based on several factors, but is mainly focused on the weighted risk associated with each type of asset held by the bank. The capital requirements guidelines are used to create capital ratios, which can then be used to evaluate and compare lending institutions based on their relative strength and safety. An adequately capitalized institution, based on the Federal Deposit Insurance Act, must have a Tier 1 capital-to-risk weighted assets ratio of at least 4%. Institutions with a ratio below 4% are considered undercapitalized, and those below 3% are significantly undercapitalized.
History of Capital Requirements
Global capital requirements have swung higher and lower over the years. Capital requirements tend to increase following a financial crisis or economic recession. An angry public and uneasy investment climate usually prove to be the catalysts for legislative reform, especially when irresponsible financial behavior and large institutions are seen as the culprits behind the crisis or recession.
When Mexico declared in 1982 that it would be unable to service interest payments on its national debt, it sparked a global initiative that led to legislation such as the International Lending Supervision Act of 1983. Through this legislation and the support of major U.S., European and Japanese banks, the 1988 Basel Committee on Banking Regulation and Supervisory Practices announced that, for internationally active commercial banks, adequate capital requirements would be raised from 5.5 to 8% of total assets.
However, a system of applying a risk weight to different types of assets allowed banks to hold less capital in relation to total assets. Normal commercial loans were given a weight of 1 (meaning that for every $1 of commercial loans held on a bank’s balance sheet, the bank would be required to hold eight cents of capital), but standard residential mortgages were given a weight of 0.5, mortgage-backed securities (MBS) issued by Fannie Mae or Freddie Mac were given a weight of 0.2 and short-term government securities were given a weight of 0. By managing assets accordingly, major banks could maintain lower capital ratios than before.
The global financial crisis of 2008 provided the impetus for the passing of the Dodd-Frank Act of 2010, which was created to ensure that the largest U.S. banks maintain enough capital to withstand systematic shocks to the banking system.
Credit: Investopedia.com
