Capital adequacy requirements are regulations imposed on banks and financial institutions to ensure that they maintain a sufficient level of capital to absorb potential losses and protect depositors and other stakeholders. These requirements are designed to promote the stability and soundness of the financial system. The two primary frameworks for capital adequacy requirements are Basel I and Basel III. Let’s explore them in more detail:
- Basel I:
Basel I, introduced in 1988 by the Basel Committee on Banking Supervision, established the first international capital adequacy framework. It mandated that banks should maintain a minimum capital adequacy ratio (CAR) of 8% based on their risk-weighted assets (RWAs). The risk weights assigned to different categories of assets were relatively simple and standardized.
The risk weights under Basel I were as follows:
- 0% for cash, government bonds, and central bank reserves
- 20% for claims on OECD banks
- 50% for residential mortgages
- 100% for corporate loans and other assets
While Basel I provided a standardized approach, it had limitations in capturing the varying degrees of risk among different asset classes and did not account for off-balance-sheet exposures.
- Basel III:
Basel III is an updated framework introduced in response to the 2008 financial crisis. It aims to strengthen the banking sector’s resilience, improve risk management, and address the shortcomings of Basel I. Basel III introduced more sophisticated risk-based capital requirements and additional capital buffers. Some key elements of Basel III include:
a. Minimum Capital Requirements: Basel III retains the minimum capital requirement of 8% CAR but introduces a stricter definition of capital. It emphasizes the importance of high-quality Tier 1 capital, which includes common equity and retained earnings.
b. Risk-Based Capital Requirements: Basel III enhances the risk sensitivity of capital requirements. It introduces more refined risk weights based on the creditworthiness of borrowers and the nature of assets. Banks are required to calculate RWAs using standardized approaches or internal models, subject to regulatory oversight.
c. Capital Conservation Buffer: Basel III introduces a capital conservation buffer of 2.5% of RWAs. Banks must maintain this buffer in addition to the minimum capital requirement. The buffer serves as a cushion during periods of economic stress and allows banks to continue lending and absorbing losses without breaching capital requirements.
d. Countercyclical Buffer: Basel III introduces a countercyclical buffer that can be implemented by national authorities during periods of excessive credit growth. The buffer requires banks to hold additional capital to build up defenses against systemic risks associated with boom-bust cycles.
e. Liquidity Coverage Ratio (LCR): Basel III introduces the LCR, which mandates banks to maintain a minimum level of high-quality liquid assets to meet their liquidity needs over a 30-day period of stress.
f. Leverage Ratio: Basel III introduces a non-risk-based leverage ratio as a supplementary measure to the risk-based capital requirements. The leverage ratio measures a bank’s Tier 1 capital in relation to its total exposure, providing a simple measure of capital adequacy.
These are some key components of Basel III, which is being implemented gradually by regulatory authorities worldwide. It aims to enhance the resilience and stability of banks by ensuring they maintain adequate capital to absorb losses and support their activities in various economic conditions.
It’s important to note that capital adequacy requirements may vary across jurisdictions, as national regulators have the flexibility to adopt the Basel standards while incorporating additional measures based on local conditions and risks.
