5.20: Capital Requirement

Capital requirements are regulatory standards that compel banks to maintain a minimum amount of capital relative to the risks they assume. This ensures banks can absorb potential losses without collapsing, thereby protecting depositors and maintaining financial stability.

The Capital Adequacy Ratio is the primary measure used to evaluate a bank’s capital strength. It is calculated as:

Risk Weighting Risk weighting assigns different values to assets depending on their risk profile:

• Low-risk assets, like short-term government securities, may have a 0% weight, meaning they do not count toward RWAs.
• Higher-risk assets, such as unsecured personal loans, often carry a 100% weight, meaning their full value counts toward RWAs.

Example If a bank holds:

• $5 million in investment-grade corporate bonds with a 50% risk weight → $5m × 50% = $2.5m RWAs
• $5 million in mortgages with a 100% risk weight → $5m × 100% = $5m RWAs

Total RWAs = $2.5m + $5m = $7.5m With $1 million in capital:

Regulatory Frameworks In the U.S., the Federal Reserve enforces capital requirements, which can be stricter than international minimums. Globally, the Basel III framework requires:

• Total CAR: At least 8%
• Tier 1 Capital Ratio: At least 6%
• Common Equity Tier 1 (CET1) Ratio: At least 4.5% Additional capital buffers are required for systemically important financial institutions. These rules, strengthened after the 2008 global financial crisis, aim to prevent bank failures from triggering systemic instability.

Adequate capital is not only a regulatory obligation but also a cornerstone of sound risk management. By maintaining strong capital levels, banks reinforce depositor trust, preserve market confidence, and remain resilient during periods of financial stress.

Capital requirements are the minimum amount of capital that regulators mandate banks to hold. These requirements help ensure that banks can absorb losses and continue operating during periods of financial stress.

One key measure is the Capital Adequacy Ratio, or CAR. It compares a bank’s capital to its risk-weighted assets.

For example, government bonds are considered very safe and may carry a risk weight of zero percent. Unsecured loans, which are riskier, may carry a risk weight of one hundred percent. So, if a bank holds one million dollars in government bonds and one million dollars in unsecured loans, only the loans count toward risk-weighted assets. That gives a total of one million dollars in risk-weighted assets.

Now, suppose the bank has one hundred twenty thousand dollars in capital. The CAR would be 12 percent.

A higher CAR means the bank is better able to absorb losses and protect depositors. It also helps prevent panic and bank runs that can trigger broader financial instability.

Capital requirements are based on Basel III, a global framework introduced after the 2008 crisis. Under this system, CAR levels vary by a bank’s size and risk.