Capital requirements

Capital requirements, also referred to as minimum mandatory capital adequacy require- ments, constitute the cornerstone of banking regulation in advanced and emerging economies. They are designed to ensure that banks and depository institutions more generally hold an adequate amount of capital to withstand losses on their assets during periods of stress. Against this backdrop, minimum capital requirements serve as a buffer to reduce the risk of banks becoming insolvent and thus unable to carry out their activi- ties on an ongoing basis, eventually protecting depositors and taxpayers and fostering the stability of the financial system as a whole. Notice that in order to ensure their solvency and reinforce the confidence of depositors and investors, banks may voluntarily choose to maintain capital adequacy ratios above the regulatory minimum.

Since the implementation of the Basel I Agreements on capital adequacy in 1988, minimum capital requirements applied to banks are "risk-weighted", so that the level of capital that a bank must hold is specified with respect to the riskiness of its asset portfolio. For instance, the higher (lower) the risk profile of a bank's credit portfolio (as indicated by the rating ascribed to the various assets by credit rating agencies or by the bank itself), the higher (lower) the amount of capital that the bank is required to set aside to absorb future unexpected losses (see Basel Committee on Banking Supervision, 1988, pp. 8-13).

Now, the outburst of the 2008-09 financial crisis has inflicted considerable losses to the whole banking sector. Following a massive depreciation of their assets, many interna- tionally active banks, which prior to the crisis were in compliance with minimum capital regulatory requirements, were forced to write down a substantial portion of their assets, leading in some cases to an erosion of their capital base.

In order to promote a more resilient global banking system and prevent the recurrence of another systemic crisis, the Basel Committee on Banking Supervision (2011) agreed upon a set of measures (known as the Basel III Agreements), which can be summarized into two main areas. First, global banks should strengthen the quality and quantity of their capital base. To do so, Basel III introduces a more stringent definition of bank capital (especially of the Tier 1 component, which has the highest loss-absorbency capacity) and requires banks to hold an additional capital conservation buffer in excess of their minimum regulatory requirements, which can be drawn down as losses materialize. Second, the Basel III capital adequacy framework adds a macro-prudential overlay to the setting of regulatory capital requirements, as epitomized, for instance, by the introduc- tion of the countercyclical capital buffer (CCB). This buffer, which can be increased up to

2.5 percent of risk-weighted assets at the discretion of national supervisory authorities, is aimed at protecting banks from periods of "excess aggregate credit growth [. . .] asso- ciated with a build-up of system-wide risk" (Basel Committee on Banking Supervision, 2011, p. 65). The macroprudential orientation of the CCB stems from the fact that buffer adjustments "breathe with the cycle"; that is to say, they take into explicit consideration the macro-financial environment in which banks operate rather than treating them in isolation - as was the case under the Basel II Accords, which were in force prior to the 2008-09 financial crisis.

While the Basel III reform has the merit of supplementing traditional micro-prudential regulation with a broader macro-prudential perspective, its contribution to systemic stability remains controversial. On the one hand, higher capital requirements could be effective in addressing systemic risk, both through the imposition of capital surcharges on too-big-to-fail banks (thereby internalizing the risk they pose to systemic stability) and the implementation of countercyclical capital requirements in times of excessive credit growth. On the other hand, however, the effectiveness of tightened capital require- ments in promoting a more stable financial system hinges on two main factors. First, the riskiness of banks' assets must be correctly measured. In this respect, one of the leading assumptions behind the Basel methodology is that the risk of any specific asset (or pool of assets) can be modelled and objectively measured by means of sophisticated quantita- tive risk management techniques (often relying on past data), and that this measure can then be used as an input for computing banks' capital requirements. However, as plainly exemplified by the 2008-09 financial crisis, the risk inherent to an asset is hardly measur- able and can increase very suddenly, especially during times of market stress. This point brings to the fore the fundamental distinction between risk and uncertainty, highlighted by Keynes (1936 [2007]) and central to the post-Keynesian analysis, according to which uncertainty cannot be reduced to a truly quantifiable risk by means of any computational techniques (see also Davidson, 2006).

Second, even assuming that risks are properly measured, banks may circumvent increased capital adequacy requirements by transferring some of their (riskiest) assets off their balance sheets to ad hoc created entities in order to maintain their profitability (the so-called boundary problem in financial regulation; see Goodhart, 2008). If this is the case, then higher capital requirements may even (perversely) lead to an increase in bank lending, especially as, in an endogenous-money framework, banks do not have to dispose of a relevant amount of deposits to lend to any kind of economic agents.

All in all, instead of insisting on imposing higher global minimum capital standards, policy makers ought to better strengthen their efforts to implement deep structural reforms aimed at addressing banks' multifunctionality and excessive bank lending, which lie at the root of systemic risk and impinge negatively on financial stability (see Panzera and Rossi, 2011, pp. 321-3). A major step in this direction would be to reform the banks' bookkeeping structure, which, to date, does not disentangle the two main functions performed by banks; that is, the "monetary function" and the "financial intermediary function", and thus lacks an operational separation between money and credit (see Rossi, 2007).

See also:

Asset-based reserve requirements; Basel Agreements; BIS macro-prudential approach; Financial crisis; Financial instability; Money and credit.