Capital requirement

The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted. Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence each country's banking capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords (Basel Accord). This framework is now being replaced by a new and significantly more complex capital adequacy framework commonly known as Basel II. While Basel II significantly alters the calculation of the risk weights, it leaves alone the calculation of the capital. The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord.

Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework. Brazil limits bank lending to 10 times the bank's capital, adjusted to inflation . Most developed countries and Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate. Every year developed country banks are losing their ability to lend by an average of 3% inflation rate times 12. This has led banks away from lending, given rise to pension funds, hedge funds, and private equity as prime "lenders", destroyed bank credit analysis departments, and, as a result, yielded an upsurge of bad loans due to inadequate lending staffs. The 5 C's of Credit, Character, Cash Flow, Collateral, Conditions and Capital, have been substituted by one single criteria. While the international standards of bank capital were laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.

Examples of national regulators implementing Basel II include the FSA in the UK, BAFIN in Germany, and OSFI in Canada.

An example of a national regulator implementing Basel I, but not Basel II, is in the United States. Depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report.

Regulatory capital
In the Basel I accord bank capital was divided into two "tiers", each with some subdivisions.

Tier 1 (core) capital
Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200.

Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. These are commonly referred to as upper tier one capital.

Tier 2 (supplementary) capital
There are several classifications of tier 2 capital, also known as supplementary capital. In the Basel I accord, these are categorised as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Undisclosed Reserves
Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results

Revaluation reserves
A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a Bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

General provisions
A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.

Hybrid instruments
Hybrids are instruments that have some characteristics of both debt and shareholders' equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the Bank, they may be counted as capital.

Subordinated-term debt
Subordinated-term debt is debt that is not redeemable (it cannot be called upon to be repaid) for a set (usually long) term and ranks lower than (it will only be paid out after) ordinary depositors of the bank.

Common capital ratios

 * Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets
 * Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets
 * Leverage ratio = Tier 1 capital / Average total consolidated assets
 * Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets

Example
Listed below are the capital ratios in Citigroup at the end of 2003.


 * (1) Tier 1 capital divided by adjusted average assets.


 * (1) Tier 1 capital excludes unrealized gains and losses on debt securities available-for-sale in accordance with regulatory risk-based capital guidelines. The federal bank regulatory agencies permit institutions to include in Tier 2 capital up to 45% of pretax net unrealized holding gains on available-for-sale equity securities with readily determinable fair values. Institutions are required to deduct from Tier 1 capital net unrealized holding losses on available-for-sale equity securities with readily determinable fair values, net of tax.


 * (2) The increase in intangible assets is primarily due to the acquisition of the Sears credit card portfolio in November 2003.


 * (3) Represents unconsolidated banking and finance subsidiaries.


 * (4) Includable up to 1.25% of risk-adjusted assets. Any excess allowance is deducted from risk-adjusted assets.


 * (5) Includes qualifying subordinated debt in an amount not exceeding 50% of Tier 1 capital.


 * (6) Includes risk-weighted credit equivalent amounts, net of applicable bilateral netting agreements, of $39.1 billion for interest rate, commodity and equity derivative contracts and foreign exchange contracts, as of December 31, 2003, compared to $31.5 billion as of December 31, 2002. Market risk-equivalent assets included in risk-adjusted assets amounted to $40.6 billion and $30.6 billion at December 31, 2003 and 2002, respectively. Risk-adjusted assets also includes the effect of other 88off-balance sheet99 exposures such as unused loan commitments and 88letters of credit99 and reflects deductions for certain intangible assets and any excess allowance for credit losses.