Capital requirements are rules set by regulators that require banks to hold a minimum level of capital (shareholders’ funds) relative to their risk-weighted assets. Their purpose is to ensure banks can absorb losses, protect depositors, and reduce the risk of bank failure and financial crises.
Example of Capital Requirement
Suppose a bank has £100 million of risk-weighted assets (RWA) for example bank loans, mortgages.
- The regulator requires a minimum capital ratio of 10%.
- This means the bank must hold at least £10 million of capital. (liquid cash)
Balance sheet (simplified):
- Assets: £100m
- Capital (equity): £10m
- Borrowed funds (deposits & debt): £90m
- If the bank suffers losses of £6m, capital falls from £10m to £4m, but the bank is still solvent.
- If losses exceed £10m, capital is wiped out and the bank fails.
Types of Capital Requirements
- Countercyclical Capital Buffer (CCyB): – Set between 0–2.5% of risk-weighted assets and raised during credit booms (e.g. UK CCyB raised after periods of rapid credit growth).
- Systemically Important Bank (SIB) Buffer: – Large or “too-big-to-fail” banks (e.g. HSBC, Barclays) must hold additional capital because their failure would damage the whole economy.
- Leverage Ratio Requirement: – A simple non-risk-weighted rule (e.g. minimum 3%) to prevent banks from becoming excessively leveraged even if assets appear low risk.
- Stress-test capital requirements: – Regulators require banks to show they can maintain capital ratios under severe recession scenarios, often forcing banks to hold capital above minimum levels.
- Minimum capital ratios
Importance of Capital Requirements
- Capital acts as a buffer against unexpected losses.
- Strong capital buffers also increase confidence in the banking system, making it more resilient during recessions.
- Higher capital ratios improve financial stability and protect depositors and make banks safer but can reduce lending (and profitability) in the short run.
Why did Capital Requirements Fail in the Run up to Credit Crunch?
In the run-up to the 2007–08 credit crunch, capital requirements failed to prevent excessive risk-taking and leverage.
- Banks appeared well capitalised under Basel II, but capital ratios were based on risk-weighted assets, which underestimated the true risk of complex products such as mortgage-backed securities and CDOs.
- Pro-cyclical rules: Capital requirements fell in booms (when risk looked low) and rose in recessions, amplifying the cycle. See: Financial instability hypothesis
- Failure of Credit rating agencies to adequately address the risk of mortgage-backed securities
- Banks also relied heavily on internal risk models, allowing them to hold very low capital against assets that later proved highly risky.
- Risks often sat off balance sheet (e.g. special purpose vehicles), so they required little or no capital. When house prices fell and losses emerged, capital buffers were too small and of poor quality, leading to bank failures, forced deleveraging, and government bailouts
- Banks appeared well capitalised on a risk-weighted basis but were actually highly leveraged (e.g. Northern Rock, Lehman Brothers). Highly leveraged means they were lending mortgages based on borrowed money (often on short-term money markets, which were considered safe and highly liquid) until the credit crunch, and money dried up.
Are Capital Requirements best policy?
Capital requirements are widely seen as one of the most effective policies for financial stability because they force banks to hold enough capital to absorb losses and reduce the risk of failure. By limiting excessive leverage and risk-taking, they make banking crises less likely and reduce the need for taxpayer bailouts, as shown by reforms after the 2008 financial crisis.
- However, capital requirements are not sufficient on their own: banks can sometimes game the system and put risk off balance books.
- Also, if too strict higher capital ratios may reduce lending in the short run.
- Capital requirements need to be also combined with leverage ratios, stress tests, and liquidity requirements.
Related
About The Author
