Capital requirement (also known as Regulatory capital or Capital adequacy) is the amount of capital a bank or other financial institution has to hold by its financial regulator. This is in the context of fractional reserve banking and is usually expressed as a capital adequacy ratio of liquid assets that must be held compared to the amount of money that is lent out. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals.
Tier
1 capital
Tier 1 capital
is the core measure
of a bank's financial
strength from a regulator's
point of view.
It is composed of
core capital which
consists primarily of
common stock and
disclosed reserves (or
retained earnings), but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed
that banks have used innovative instruments over the years to generate Tier 1
capital; these are subject to stringent conditions and are limited to a maximum
of 15% of total.
Tier
1 capital.
Each
country's banking regulator, however, has some discretion over how differing
financial instruments may count in a capital calculation. This is appropriate,
as the legal framework varies in different legal systems.
The
theoretical reason for holding capital is that it should provide protection
against unexpected losses. Note that this is not the same as expected losses,
which are covered by provisions, reserves and current year profits. In Basel I
agreement, Tier 1 capital is a minimum of 4% ownership equity but investors
generally require a ratio of 10%. Tier 1 capital should be greater than 150% of
the minimum requirement.
Tier
2 capital
Tier
2 capital, or supplementary capital, include a number of important and
legitimate constituents of a bank's capital base.[1] These forms of banking capital were largely
standardized in the Basel I accord, issued by the Basel Committee on Banking
Supervision and left untouched by the Basel II accord. National regulators of
most countries around the world have implemented these standards in local
legislation. In the calculation of regulatory capital, Tier 2 is limited to
100% of Tier 1 capital.
Capital
Tiers and their constituents
Tier
1: Core Capital
a.
Paid up capital
b. Non-repayable
share premium account
c. Statutory
reserve
d. General
reserve
e. Retained
earnings
f. Minority
interest in subsidiaries
g. Non-cumulative
irredeemable preference shares
h. Dividend
equalization account
Tier
2: Supplementary Capital
a. General
provision (Unclassified loans, Special Mention Account loans and off Balance
Sheet exposures)
b. Revaluation
reserves for fixed assets, securities and equity instruments
c. All
other preference shares
d. Subordinated
debt >= 5 years
Tier
3: Additional Supplementary
Capital
(For Market Risk only)
Short
term subordinated debt (2 years<= maturity