Regulatory Capital

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Regulatory Capital</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#runs">bank run</a><p class="word_list"> <a href="#harmonization">harmonization</a><p class="word_list"> <a href="#Regulatory arbitrage">regulatory arbitrage</a><p class="word_list"> <a href="#regulatory capital">regulatory capital</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table5"> <tr> <td width="160">  </td> <td width="11"> </td> </tr> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">A significant trend in financial regulation over the past half century has been the increased application of <b> <a name="regulatory capital">regulatory capital</a></b> requirements to financial institutions. Regulatory <a href="../articles/capital_allocation.htm">capital</a> requirements largely originated in the United States as a response to the deregulation of the 1970s and 1980s. Because of the <a href="../articles/united_states_financial_regulation.htm">Glass-<span style="font-size: 12.0pt; font-family: Times New Roman">Steagall</span></a><span style="font-size: 12.0pt; font-family: Times New Roman"> distinction between <a href="../articles/united_states_financial_regulation.htm"> commercial banks</a> and <a href="../articles/european_financial_regulation.htm">securities firms</a>, two parallel regimes developed. One is for banks and is administered by the <a href="../articles/united_states_financial_regulation.htm">Fed</a>, <a href="../articles/united_states_financial_regulation.htm">OCC</a> and <a href="../articles/united_states_financial_regulation.htm">FDIC</a>. The other is for securities firms and is administered by the <a href="../articles/united_states_financial_regulation.htm">SEC</a>. Under this bifurcated system, capital requirements have been implemented for different purposes, reflecting the differing natures of banks and securities firms.</span></p> <p class="body">Traditionally, banks were primarily exposed to <a href="../articles/credit_risk.htm">credit risk</a>. They held <a href="../articles/liquidity.htm">illiquid</a> portfolios of loans supported by deposits. Loans could be liquidated rapidly only at “fire sale” prices. This placed banks at risk of <b><a name="runs">runs</a></b>. 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.  </p> <p class="body"> <a href="../articles/united_states_financial_regulation.htm">Deposit insurance</a> and lender-of-last-resort provisions implemented since the <a href="../articles/united_states_financial_regulation.htm"> Crash of 1929</a> 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.</p> <p class="body">The primary purpose of capital requirements for securities firms was to protect clients who might have funds or <a href="../articles/security.htm">securities</a> on deposit with a firm. Securities firms mostly took market risk. They held liquid portfolios of marketable securities supported by secured financing such as <a href="../articles/repo.htm">repos</a>. 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.  </p> <p class="body">In a nutshell, banks entailed <a href="../articles_old/glossarysystemicrisk.htm">systemic risk</a>. 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 <a href="../articles/common_stock.htm">equity</a> 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 <a href="../articles/united_states_financial_regulation.htm">primary capital</a> requirements set by the SEC, OCC and FDIC while US securities firms were subject to the SEC's <a href="../articles/united_states_financial_regulation.htm">Uniform Net Capital Rule</a> (UNCR).</p> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table6"> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table><p class="body"><b><a name="Regulatory arbitrage">Regulatory arbitrage</a></b> is any transaction that has little or no economic impact on a financial institution while either increasing its capital or decreasing its required capital. Just as trading <a href="../articles/arbitrage.htm">arbitrage</a> 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.</p> <p class="body">The UNCR is a <a href="../articles/capital_allocation.htm">risk-based capital</a> requirement, but primary capital was based on a bank's <a href="../articles/capital_allocation.htm">capital ratio</a>. This made it particularly subject to regulatory arbitrage. During the mid-1980s, US commercial banks used <font FACE="Times.New.Roman0150" SIZE="3"> 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 <a href="../articles/basle_committee.htm">1988 Basel Accord</a>. It imposed a risk-based capital requirement on banks, but its crude system of risk weights was itself easy to arbitrage. Explosive growth in <a href="../articles/credit_derivative.htm">credit derivative</a> and <a href="../articles/securitization.htm">securitization</a> 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 <a href="../articles/basle_committee.htm">Basel II</a>.</font></p> <p class="body"><font face="Times.New.Roman0150">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.</font></p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table7"> <tr> <td align="right" width="9"> </td> <td width="336">  <p style="margin-top: 0; margin-bottom: 2" class="ad_legend"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82402"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82402;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> </table> <p>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: </p> <ol> <li> <p class="bullet_line_space">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 <b><a name="harmonization">harmonization</a></b> can create a competitive “level playing field” between the two. This was the philosophy underlying Europe’s 1993 <span style="font-family: Times New Roman"> <a href="../articles/european_financial_regulation.htm">Capital Adequacy Directive</a> (CAD)</span>. It was hoped that the Basel Accords might extend such harmonization to US securities firms, several of which competed internationally.</li> <li> <p class="bullet_line_space">Some securities firms were active in the <a href="../articles/exchange_traded.htm">OTC</a> <a href="../articles/derivative_instrument.htm">derivatives</a> 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. </li> </ol> <p class="body">In Europe, <span style="font-family: Times New Roman">the United Kingdom distinguished between banks and securities firms, but on the continent, Germany's system of <a href="../articles/european_financial_regulation.htm">universal banks</a> predominated. As Europe moved towards unification, the 1993 CAD harmonized the regulation of British securities firms and Germany's universal banks. The <a href="../articles/basle_committee.htm">1988 Basel Accord</a> had leveled the competitive playing field among different countries' banks. A 1991 <a href="../articles/basle_committee.htm">Basel-IOSCO initiative</a> attempted to extend this harmonization to US securities firms, which remained subject to the SEC's separate UNCR. That initiative failed.</span></p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table8"> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body"><span style="font-family: Times New Roman">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. </span></p> <p class="body"><span style="font-family: Times New Roman">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 <a href="../articles/united_states_financial_regulation.htm">United States financial regulation</a>) such an approach seems unlikely. </span></p> <p class="body"><span style="font-family: Times New Roman">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.</span></p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table9"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table10"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/basle_committee.htm">Basel Committee</a> A committee of representatives from central banks and regulatory authorities that has played a leading role in standardizing bank regulations across jurisdictions.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/capital_allocation.htm">capital</a> A firm's value—assets minus liabilities.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/economic_capital.htm">economic capital</a> </strong> Capital held for economic (as opposed to regulatory) purposes.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/european_financial_regulation.htm">European financial regulation</a> An overview.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk_management.htm">financial risk management</a> Practices by which a firm optimizes the manner in which it takes financial risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/united_states_financial_regulation.htm">United States financial regulation</a> An overview.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table11"> <tr> <td width="100%"> <p class="explanatory_text">Matten (<a target="_blank" href="http://www.riskbook.com/link/matten_c_(2000).htm">2000</a>) is the definitive non-technical book on bank capital, covering both economic and regulatory capital. 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