Bank capital regulation is a key component in maintaining financial stability. This requires an appropriate level of capital, a structure that addresses a range of concerns, and complementary measures to ensure the system remains fair and efficient. Regulation should be phased in gradually to avoid sudden disruptions in the supply of bank credit. It should also consider the social costs of the new capital requirement.
US regulators have adopted Basel III, which sets higher capital requirements for many banks. The regulations will take effect over the next several years. They were intended to address the great financial crisis. The new rules were designed to encourage banks to build capital and bolster their balance sheets. The regulations include categories based on the banks’ total assets. If a bank falls below a “well capitalized” category, it will face heightened supervision and may be forced into receivership.
The current system of capital regulation has changed dramatically over the last several decades. It has evolved from the early 1900s, when minimum capital requirements were set based on size and risk. In 1914, the Comptroller of the Currency, John Skelton Williams, proposed a minimum capital-to-deposit ratio of one-tenth. However, this proposal did not become law.
Regulations apply a combination of T1 and T2 to calculate a bank’s RWA. The ratio of T1 capital to total assets is an easy way to determine the quality of capital. In addition, the ratio is risk-agnostic, and it requires banks to have a capital ratio between three and four percent.
Higher capital requirements restrict banking activity and increase bank costs. As banks become more risk-averse, their ability to lend and invest can be inhibited. In addition, these regulations reduce competition in the financial sector. Therefore, higher capital requirements can lead to lower economic growth. The main purpose of these regulations is to increase the stability of financial institutions.
Regulations have a long history. The original capital requirements of banks were not set at a general level. Minimum capital requirements were established for specific institutions. Only in the 1980s were capital limits legally enforced. Even then, the legal authority for such regulations was uncertain. As a result, the Federal Reserve lost a court battle over the issue. However, today, banks are required to maintain adequate capital levels. It is crucial for the financial system to have the right amount of capital in order to avoid going under.
The 2008 financial crisis was made worse by the failure of large financial institutions to replace lost capital. They did not become a systemic failure overnight; they began to deplete their capital in March 2008, and by mid-September 2008, the bank collapsed. Regulatory capital has been measured as the difference between the value of assets and debts.
Bank capital regulations are necessary to protect the financial system. Capital requirements require banks to hold a minimum amount of liquid capital to cover their liabilities. They are also intended to ensure that the banks can sustain unforeseen losses.