Regulatory Capital

Explained:

bank run

harmonization

regulatory arbitrage

regulatory capital


 
   

A significant trend in financial regulation over the past half century has been the increased application of regulatory capital requirements to financial institutions. Regulatory capital requirements largely originated in the United States as a response to the deregulation of the 1970s and 1980s. Because of the Glass-Steagall distinction between commercial banks and securities firms, two parallel regimes developed. One is for banks and is administered by the Fed, OCC and FDIC. The other is for securities firms and is administered by the SEC. Under this bifurcated system, capital requirements have been implemented for different purposes, reflecting the differing natures of banks and securities firms.

Traditionally, banks were primarily exposed to credit risk. They held illiquid portfolios of loans supported by deposits. Loans could be liquidated rapidly only at "fire sale" prices. This placed banks at risk of runs. If depositors feared a bank might fail, they would withdraw their deposits. Forced to liquidate its loan portfolio, the bank would succumb to staggering losses on those sales.  

   

Deposit insurance and lender-of-last-resort provisions implemented since the Crash of 1929 eliminated the risk of bank runs, but they introduced a new problem. Depositors no longer had an incentive to consider a bank's financial viability before depositing funds. Without such marketplace discipline, regulators were forced to intervene. One solution was to impose minimum capital requirements on banks. Because of the high cost of liquidating a bank, such requirements would be based upon the value of a bank as a going concern.

The primary purpose of capital requirements for securities firms was to protect clients who might have funds or securities on deposit with a firm. Securities firms mostly took market risk. They held liquid portfolios of marketable securities supported by secured financing such as repos. A troubled firm's portfolio could be unwound quickly at market prices. For this reason, capital requirements were based upon the liquidation value of a firm.  

   

In a nutshell, banks entailed systemic risk. Securities firms did not. Regulators would strive to keep a troubled bank operating. They would gladly unwind a troubled securities firm. Banks needed long-term capital in the form of equity or long-term subordinated debt. Securities firms could operate with more transient capital, including short-term subordinated debt. It made sense to have different capital regimes for banks and securities firms. The Glass Steagal separation of commercial banks and securities firms facilitated this. By the mid-1980s, US commercial banks were subject to primary capital requirements set by the SEC, OCC and FDIC while US securities firms were subject to the SEC's Uniform Net Capital Rule (UNCR).

Regulatory arbitrage is any transaction that has little or no economic impact on a financial institution while either increasing its capital or decreasing its regulatory capital requirement. Just as trading arbitrage identifies and exploits inconsistencies in market prices, regulatory arbitrage identifies and exploits inconsistencies in capital regulations. Regulatory arbitrage undermines the effectiveness of capital regulations. It is one of the primary motivators for regulators to continually improve capital requirements.

The UNCR is a risk-based capital requirement, but primary capital was based on a bank's capital ratio. This made it particularly subject to regulatory arbitrage. During the mid-1980s, US commercial banks used letters of credit, loan commitments and swaps to move assets off their balance sheets. Some sold their headquarters buildings to realize a capital gain and then leased them back. This was one motivator for US bank regulators to participate in the development of the 1988 Basel Accord. It imposed a risk-based capital requirement on banks, but its crude system of risk weights was itself easy to arbitrage. Explosive growth in credit derivative and securitization markets during the 1990s can largely be ascribed to regulatory arbitrage of the 1988 Basel Accord, both in the United States and abroad. That regulatory arbitrage, in turn, motivated the development of Basel II.

Inevitably, there is a tradeoff between strengthening capital regulations against regulatory arbitrage and keeping those regulations simple and affordable for the financial institutions who are subject to them. Basel II is far more complicated than the 1988 Basel Accord. This may have contributed to the decision by US regulators to apply Basel II to only the largest US banks.

Another goal of the Basel Accords, at least for some regulators, was to harmonize capital regulations for banks and securities firms. Account insurance and regulations requiring segregation of investor assets had largely mitigated the risks that capital requirements for securities firms were intended to address. Increasingly, capital requirements for securities firms were justified on two new grounds:

  1. Although securities firms do not pose the same systemic risks as banks, it was argued that bank securities operations and non-bank securities firms should face the same capital requirements. Such harmonization can create a competitive "level playing field" between the two. This was the philosophy underlying Europe's 1993 Capital Adequacy Directive (CAD). It was hoped that the Basel Accords might extend such harmonization to US securities firms, several of which competed internationally.

  2. Some securities firms were active in the OTC derivatives markets. Unlike traditional securities, many OTC derivatives were illiquid and posed significant credit risk for one or both counterparties. This was compounded by their high leverage that could inflict staggering market losses on unwary firms. Fears were mounting that the failure of one derivatives dealer could cause credit losses at other dealers. For the first time, non-bank securities firms were posing systemic risks.

 

In Europe, the United Kingdom distinguished between banks and securities firms, but on the continent, Germany's system of universal banks predominated. As Europe moved towards unification, the 1993 CAD harmonized the regulation of British securities firms and Germany's universal banks. The 1988 Basel Accord had leveled the competitive playing field among different countries' banks. A 1991 Basel-IOSCO initiative attempted to extend this harmonization to US securities firms, which remained subject to the SEC's separate UNCR. That initiative failed.

Harmonization has never been a priority for the SEC. The SEC is largely content with bifurcated regulation. Indeed, the SEC has voiced concerns that adopting Basel-like requirements in place of the UNCR would needlessly dilute capital requirements for US securities firms.

The other justification for applying capital requirements to securities firms—the systemic risk posed by OTC derivatives—is also not compelling. Many US securities firms have little or no involvement with OTC derivatives. If OTC derivatives are the problem, it would seem appropriate to apply capital requirements based on the extent to which a securities firm is exposed to them. In a political environment that is strongly opposed to direct regulation of OTC derivatives (see this glossary's article United States financial regulation) such an approach seems unlikely.

For whatever reason, the SEC continues to maintain its own UNCR capital regulation for US securities firms. Questions as to whether this should be harmonized with the Basel Accords or simply abandoned as unnecessary remain open. Occasionally debates flair, but no action on either possibility appears likely in the near future.

Related Books

       

Related Internal Links

Basel Committee A committee of representatives from central banks and regulatory authorities that has played a leading role in standardizing bank regulations across jurisdictions.

capital A firm's value—assets minus liabilities.

economic capital Capital held for economic (as opposed to regulatory) purposes.

European financial regulation An overview.

financial risk management Practices by which a firm optimizes the manner in which it takes financial risk.

United States financial regulation An overview.

Related Forum Discussions

Regulatory capital Vs economic capital 30 Dec 2003
Differences between regulatory and economic capital.

http://www.riskglossary.com

copyright © Glyn A. Holton, 2004

Although the information in this website has been presented with care and obtained from sources the author believes to be reliable, there is no guarantee that it is accurate. Such information may be incomplete, condensed, outdated or presented with errors. The content of the website is for information purposes only. It is provided gratuitously, so the author shall not be liable under any theory for any damages suffered by any user. The author does not provide investment advice, and this website is not a vehicle for communicating investment advice.