Capital requirement

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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 assets, as weighted by ratios dictated under the relevant Accord.

Each national regulator normally has a differing way of calculating bank capital, to meet their own requirements and legal framework, but the international standards of bank capital were laid down in the 1988 Basel I accord and have been little changed since.

A good example of a national regulator implementing these 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 well-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. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report.

1 Regulatory Capital
- 1.1 Tier 1 (Core) Capital
- 1.2 Tier 2 (Supplementary) Capital
2 Common capital ratios
- 2.1 Example
3 See also
4 External links

[edit] Regulatory Capital

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

[edit] Tier 1 (Core) Capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amounts 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.

[edit] 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.

[edit] 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

[edit] 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.

[edit] 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.

[edit] 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.

[edit] 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 (it will only be paid out after) ordinary depositors of the bank.

[edit] 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

[edit] Example

Listed below are the capital ratios in Citigroup at the end of 2003 [1].

**Ratios**
At year-end	2003
Tier 1 capital	8.91%
Total capital (Tier 1 and Tier 2)	12.04%
Leverage ⁽¹⁾	5.56%
Common stockholders’ equity	7.67%

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

**Components of Capital Under Regulatory Guidelines**
In millions of dollars at year-end	2003
Tier 1 capital
Common stockholders’ equity	$ 96,889
Qualifying perpetual preferred stock	1,125
Qualifying mandatorily redeemable securities of subsidiary trusts	6,257
Minority interest	1,158
Less: Net unrealized gains on securities available-for-sale ⁽¹⁾	(2,908)
Accumulated net gains on cash flow hedges, net of tax (751) (1,242)	(751)
Intangible assets: ⁽²⁾
Goodwill	(27,581)
Other disallowed intangible assets	(6,725)
50% investment in certain subsidiaries ⁽³⁾	(45)
Other	(548)
Total Tier 1 capital	66,871
Tier 2 capital
Allowance for credit losses ⁽⁴⁾	9,545
Qualifying debt ⁽⁵⁾	13,573
Unrealized marketable equity securities gains ⁽¹⁾	399
Less: 50% investment in certain subsidiaries ⁽³⁾	(45)
Total Tier 2 capital	23,472
Total capital (Tier 1 and Tier 2)	$ 90,343
Risk-adjusted assets ⁽⁶⁾	$750,293

(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.