Risk-based capital requirements are compulsory rules set to determine the minimum regulatory capital financial institutions must maintain. These requirements exist to shield financial firms, their investors, clients, and the overall economy, ensuring that every financial institution possesses sufficient capital to absorb operating losses while maintaining a safe and efficient market.
Key Takeaways
- Risk-based capital requirements are regulatory minimums for banks established by controllers.
- Permanent floor levels exist for these requirements—8% for total risk-based capital (Tier 2) and 4% for Tier 1 risk-based capital.
- Tier 1 capital includes common stock, reserves, retained earnings, and certain preferred stock.
- Risk-based capital serves as a cushion to prevent insolvency.
Understanding Risk-Based Capital Requirement
In June 2011, the Office of the Comptroller of the Currency (OCC) introduced a rule to establish a permanent floor for risk-based capital requirements, a move supported by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (FDIC). While the rule subjects requirements to a permanent floor, it allows flexibility for risk calculation concerning certain low-risk assets.
The Collins Amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act laid down minimum risk-based capital mandates for insured depository institutions, depository institution holding firms, and Federal Reserve-supervised non-bank financial entities.
Under the Dodd-Frank regulations:
- Banks must have a total risk-based capital ratio of 8%.
- A Tier 1 risk-based capital ratio of 4.5% is required.
- A bank is tagged as “well-capitalized” if it maintains a Tier 1 ratio of 8% or more, a total risk-based capital ratio of at least 10%, and a Tier 1 leverage ratio of 5% or higher.
Special Considerations
Typically, Tier 1 capital encompasses an institution’s common stock, disclosed reserves, retained earnings, and certain preferred stock types. Total capital integrates both Tier 1 and Tier 2 capital, signifying the difference between a bank’s assets and liabilities. Each category holds specific nuances.
The Basel Committee on Banking Supervision—part of the Bank for International Settlements—regularly publishes the Basel Accords to set guidelines on how banks should calculate their capital reserves. Since the establishment of Basel I in 1988, followed by Basel II in 2004, and Basel III in response to the regulatory deficits observed during the late-2000s financial crisis, these standards facilitate banks in gauging their credit risk associated with on-balance sheet and off-balance sheet exposures.
Risk-Based Capital vs. Fixed-Capital Standards
Both risk-based capital and fixed-capital standards serve to buffer companies from insolvency, though they operate differently. While fixed-capital standards demand uniform reserve funds across companies, irrespective of individual risk levels, risk-based capital proportions capital requirements according to the specific risk level of each institution.
The insurance industry transitioned to risk-based capital standards in the 1990s after a series of insolvencies in the previous two decades. Previously, under fixed-capital standards, two insurers of identical size in the same region, although fundamentally different in risk profiles, would have been mandated to hold the same reserve capital. Post-1990s, regulatory requirements varied by insurance niche and distinctive risk levels.
Related Terms: Capital requirement, Operating losses, Office of the Comptroller of the Currency, Basel Accords, Dodd-Frank Act.
