Origins
Bank Capital Requirements are the primary tool used by regulators to ensure that financial institutions maintain a sufficient cushion of equity to absorb losses without becoming insolvent. The modern framework was formalized with the Basel I accord in 1988, though the principle has ancient roots. The doctrine is analogous to requiring a home buyer to make a down payment, ensuring they have “skin in the game” and a buffer against declining asset values.
Historically, banks in the 19th century operated with equity levels as high as 40–50%, but these levels declined significantly as the government safety net expanded throughout the 20th century. The creation of deposit insurance (FDIC in 1933) and the lender of last resort function reduced the incentive for banks to maintain large equity buffers, as creditors no longer bore the full risk of bank failure.
Structure & Function
Capital requirements operate by mandating minimum ratios of equity to assets. Under Basel I, banks were required to hold 8% capital against risk-weighted assets. Different asset classes received different weights: government bonds were weighted at 0% (considered riskless), residential mortgages at 50%, and corporate loans at 100%. This “risk-weighting” approach attempted to calibrate capital to the underlying risk of different activities.
Basel II and III introduced more sophisticated approaches, allowing major banks to use internal models to calculate their required capital. The use of risk-weighted assets has been criticized for creating incentives for regulatory arbitrage, leading institutions to hide risks in complex instruments like CDOs and sovereign debt that carried low regulatory weights but proved highly risky.
Historical Significance
The banking industry consistently resists higher requirements, arguing that equity is “expensive” and that mandating more of it will reduce lending and stifle economic growth. However, critics like Anat Admati and Martin Hellwig argue that these claims are misleading. While higher equity may lower Return on Equity (ROE), it also lowers the risk to shareholders and the public. They advocate for much higher, unweighted equity requirements of 20–30% of total assets to ensure systemic safety.
The 2008 financial crisis revealed that many banks’ equity levels were insufficient to absorb losses from mortgage-related securities. The U.S. government used TARP to force $125 billion in capital into the nine largest banks to prevent insolvency. Basel III, announced in 2010, raised minimum requirements but was criticized as a “mouse that did not roar”—still allowing dangerous levels of leverage.
Key Developments
- 1844: The Bank Act in Britain marks an early move toward regulating bank resources.
- 1933: The Glass-Steagall Act creates the FDIC, providing a safety net that inadvertently encourages lower equity buffers.
- 1988: Basel I establishes the first international standard of 8% capital against risk-weighted business lending.
- 1996: The Market Risk Amendment allows banks to use internal models for trading book capital.
- 2004: Basel II introduces more complex risk-weighting and allows major banks to use internal models.
- 2004: The SEC creates the Consolidated Supervised Entities regime, permitting leverage as high as 33-to-1.
- 2007 (August): The subprime crisis reveals that many banks’ equity levels are insufficient.
- 2008 (October): The U.S. government uses TARP to force $125 billion in capital into the nine largest banks.
- 2010 (September): Basel III is announced, raising minimum common equity requirements.
- 2011: The European Banking Authority conducts stress tests revealing significant recapitalization needs.
- 2012: Anat Admati and Martin Hellwig publish The Bankers’ New Clothes, arguing for 20–30% equity requirements.
- 2013: The Federal Reserve announces a 5% leverage ratio for the largest U.S. bank holding companies.