Remember the stock market crash and the global financial crisis of 2008? It’s hard to forget when millions of people still feel the effects of it today.
One of the biggest contributors to the crash was problems with the way agencies regulated bank capital.
Capital regulation was so complicated even professionals struggled to understand it. In addition, banks did not have enough high-quality capital. There also weren’t strong enough incentives to curb risk-taking.
What can be done to make sure another financial crisis happens again?
This article is going to teach you what bank capital and capital regulation are. Keep reading to learn about the importance of using regulation to create market stabilization.
What is Bank Capital?
Bank capital represents the net worth of a bank. It also represents the bank’s equity value to investors. Bank capital is the difference between the bank’s assets and its liabilities.
High bank capital correlates with better financial stability. This gives banks a bigger cushion to absorb losses.
Recent policy proposals would require banks to hold even more equity capital. It would result in better asset market stabilization and allow banks to absorb extreme losses.
Bank capital performs other important functions too. For example, it promotes public confidence and helps restrict excessive growth. Bank capital also protects depositors.
What is Capital Regulation?
Capital regulation is a set of standards for banks and other depository institutions. They determine how much liquid capital the banks must hold in relation to a certain level of their assets.
They create capital ratios that are used to evaluate an institution’s strength and security.
Regulatory agencies like the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board (the Fed) set regulatory capital.
While each country has its own rules and regulations, international bodies create standards too. The Bank for International Settlements (BIS) is most notable.
The Basel Committee
The Basel Committee on Banking Supervision is the primary global standard-setter for bank regulation out of the BIS.
The Committee created the Basel I, Basel II, and Basel III Accords to help standardize capital regulation across countries.
Basel I specifies a risk-weighted capital ratio. It classifies bank assets into four groups and weighs their risks.
Basel II uses more complex capital ratios that better align the risk-taking of banks with their regulatory capital. Yet, the market crash showed the weaknesses of Basel II.
The Committee released Basel III after the 2008 financial crisis. This was to tighten capital requirements on financial institutions further.
Regulators tighten capital regulations after a stock market crash, recession, or other financial crisis.
Basel III divided banks into tiers. Tier 1 capital institutions must have a ratio of at least 4%. Tier 1 capital includes stock, some preferred stock, disclosed reserves, and retained earnings.
The new accord improves transparency, monitoring, and information disclosure. This ensures banks don’t sidestep regulation.
Further Your Knowledge
Now you have a better understanding of bank capital and capital regulation. As a result, you should feel more confident in using this knowledge to help you make your own investing and banking decisions.
If you found this article helpful or interesting, make sure to check out more in the Money and Market section.
