Capital Adequacy Standards

 

A key goal of banking regulation is to ensure that banks maintain sufficient capital to absorb reasonably likely losses. In 1989, the federal banking regulators adopted a common standard for measuring capital adequacy that is broadly based on the risks of an institution’s investments. This common standard, in turn, was based on the 1988 agreement “International Convergence of Capital Measurement and Capital Standards” (commonly known as the Basel Accord) developed by the Basel Committee on Bank­ing Supervision. This committee, which is associated with the Bank for International Settlements headquartered in Switzerland, is composed of representatives of the central banks or bank supervisory authorities from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

The risk based capital standards require institutions that assume greater risk to hold higher levels of capital. Moreover, these standards take into account risks associated with activities that are not included on a bank’s balance sheet, such as the risks arising from commitments to make loans. Because they have been accepted by the bank supervisory authorities of most of the countries with major international banking centers, these standards promote safety and soundness and reduce competitive inequities among banking organizations operating within an increasingly global market.

Recognizing that the existing risk-based capital standards were in need of significant enhancements to address the activities of complex banking organizations, the Basel Committee began work to revise the Basel Accord in 1999 and, in June 2004, endorsed a revised framework, which is referred to as Basel II. Basel II has three “pillars” that make up the framework for assessing capital adequacy. Pillar I, minimum regulatory capital requirements, more closely aligns banking organizations’ capital levels with their underlying risks. Pillar II, supervisory oversight, requires supervisors to evaluate banking organizations’ capital adequacy and to encourage better risk-management techniques. Pillar III, market discipline, calls for enhanced public disclosure of banking organizations’ risk exposures.

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