What Are Capital Requirements for Banks?

Capital requirements are regulations that mandate banks hold a specific amount of their own capital in reserve. This capital acts as a financial cushion to absorb unexpected losses from their lending and investment activities. The primary goal is to ensure a bank can remain solvent during periods of economic stress. By requiring banks to have a stake in their own financial health, these rules help protect the money of depositors and maintain public confidence.

The Purpose of Capital Requirements

A significant reason for these regulations is to mitigate systemic risk. The financial system is highly interconnected, and the failure of one large institution can create a domino effect, triggering a cascade of failures across the economy. Capital requirements act as a safeguard against this, making individual banks more resilient. A well-capitalized banking sector can withstand economic shocks, preventing a single institution’s problems from spiraling into a full-blown financial crisis.

Key Components of Regulatory Capital

Regulatory capital is divided into tiers based on its quality and ability to absorb losses. The highest quality is Tier 1 capital, which allows a bank to absorb losses and continue its operations as a “going-concern.” This means the bank can handle financial hits without stopping its normal business activities.

The most important component of Tier 1 is Common Equity Tier 1 (CET1) capital. CET1 is the purest form of capital because it represents the highest loss-absorbing capacity. It primarily consists of the common stock issued by the bank and its retained earnings, which are the accumulated profits that have been reinvested back into the institution.

Another part of Tier 1 is Additional Tier 1 (AT1) capital. This category includes financial instruments that are perpetual, meaning they have no maturity date. These can be written down or converted into common equity if the bank’s financial health deteriorates.

Tier 2 capital serves a different purpose and is often called “gone-concern” capital. Its main function is to absorb losses if a bank has already failed and is being liquidated. This capital helps ensure that depositors and other senior creditors are repaid. Tier 2 capital includes items like subordinated debt and certain loan-loss reserves.

Calculating Capital Adequacy

Regulators assess capital adequacy by comparing capital to a bank’s overall risk exposure using Risk-Weighted Assets (RWAs). The RWA framework acknowledges that not all of a bank’s assets carry the same level of risk. The calculation involves assigning a risk weight to each asset. For example, cash and government securities have a low or zero risk weight, while an unsecured loan to a startup is riskier and receives a higher weight.

Once total RWAs are calculated, regulators use this figure to determine several key capital ratios. These ratios express the bank’s capital as a percentage of its risk-weighted assets. The main ratios include the CET1 Capital Ratio, the Tier 1 Capital Ratio, and the Total Capital Ratio.

Under the international framework known as Basel III, banks must meet specific minimums. The minimum CET1 Capital Ratio is 4.5%, the minimum Tier 1 Capital Ratio is 6%, and the minimum Total Capital Ratio is 8%.

Regulators also require banks to maintain a Capital Conservation Buffer of 2.5% of risk-weighted assets. This buffer is built up in good times and can be drawn down during periods of stress. Further buffers may be required for the largest banks.

The framework for calculating capital adequacy is also evolving. An update, often called the “Basel III Endgame,” is scheduled to take effect on July 1, 2025, for banks with $100 billion or more in total assets. These new rules will change how risk-weighted assets are calculated by requiring more standardized approaches for measuring risk.

The Role of Regulatory Bodies

Capital rules are established and enforced by a network of national and international regulatory bodies. At the global level, the Basel Committee on Banking Supervision (BCBS) develops and promotes consistent banking regulations, most notably through its series of Basel Accords.

While the BCBS sets international standards, it does not have enforcement authority. Implementation and enforcement are handled by national regulators in each country. In the United States, several federal agencies share this responsibility, including the Board of Governors of the Federal Reserve System (the Fed), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC).

These U.S. regulators ensure that banks operating within the country comply with capital adequacy rules. They conduct regular examinations and stress tests to assess a bank’s financial health. If a bank is found to be undercapitalized, these agencies have the authority to take corrective actions.