Regulators try to ensure that banks and other financial institutions have sufficient capital to keep them out of difficulty. This not only protects depositors, but also the wider economy, because the failure of a big bank has extensive knock-on effects.
The risk of knock-on effects that have repercussions at the level of the entire financial sector is called systemic risk.
The Basel 1 accord defined capital adequacy as a single number that was the ratio of a banks capital to its assets. There are two types of capital, tier one and tier two. The first is primarily share capital, the second other types such as preference shares and subordinated debt. The key requirement was that tier one capital was at least 8% of assets.
Each class of asset has a weight of between zero and 1 (or 100%). Very safe assets such as government debt have a zero weighting, high risk assets (such as unsecured loans) have a rating of one. Other assets have weightings somewhere in between. The weighted value of an asset is its value multiplied by the weight for that type of asset.
The Basel 1 accord has largely been replaced by new rules. Basel 2 is based on three “pillars”: minimum capital requirements, supervisory review process and market forces.
The first "pillar" is similar to the Basel 1 requirement, the second is the use of sophisticated risk models to ascertain whether additional capital (i.e. more than required by pillar 1) is necessary.
The third pillar requires more disclosure of risks, capital and risk management policies. This encourages the markets to react to the taking of high risks.
In addition to specifying levels of capital adequacy, most countries (including the UK) have regulator run guarantee funds that will pay depositors at least part of what they are owed. It is also usual for regulators to intervene to prevent outright bank defaults.
The Basel 2 rules looked increasingly inadequate in the wake of the financial crisis, and the Basel 3 rules were considerably tighter. The main changes were:
- The required level of tier one capital increased from 4% to 6%.
- Required common equity increased from 2% to 4.5%.
- In addition, a further 2.5% in common equity is required as a conservation buffer.
- An additional variable amount of counter-cyclical (i.e. higher when the economy is strong, allowed to run down when the economy is weak) buffer is required. This will vary from 0% to 2.5%.
- Total capital required rose to 8% — 10.5% including the conservation buffer, with the counter cyclical buffer on top of it.
This represents a significant change in the capital structure of banks. Its impact is weakened by being phased in over an eight year period. The gradual shift was necessary as increases in capital adequacy requirements reduce banks ability to lend (more lending on the same capital base means lower ratios) which would be highly damaging at a time of economies still emerging from recession (2010).