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
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.