Risk-based Capital Regulations

The capital base is not limited to equity plus retained earnings. It includes any debt subordinated to other commitments by the bank. Equity represents at least 50% of the total capital base for credit risk. Equity is also the "tier 1" of capital or the "core capital."

The Cooke ratio stipulates that the capital base should be at least 8% of weighted assets. The weights depend upon the credit quality of the borrowers and the transaction, as described below. For market risk, the rules are more complex because the regulations aim at capturing the economics of market risk, taking advantage of the widely available information on market parameters and prices. The basic idea was the same, defining the minimum amount of the capital charge, as a function of risks assessed either through rules defining capital charge by transaction or VaR-based risk models for market risk. After bank VaR-based models were authorized in 1996-97, they became widespread in the banking industry from the late 1990s.

Capital Requirements

Traditionally, capital represents a very small fraction of total assets of banks, especially when comparing the minimum requirements to similar ratios of non-financial institutions. A capital percentage of 8% of assets, the now famous "Cooke" ratio of capital to risk-weighted assets, is equivalent to a leverage ratio (debt/equity ratio) of 92/8 — 11.5. The high leverage of banking institutions results from a number of factors. Smooth operations of banks require easy and immediate access to financial markets, as long as the perceived risk by potential lenders remains acceptable.

The 8% ratio of capital to weighted assets seems too high if compared to average observed default rates in good conditions, and perhaps too low with portfolios of high-risk borrowers under stressed conditions. But the 8% ratio makes sense when considering diversification effects. Regulators' 8% ratio shows that they estimated that a bank could not lose more than 8% of their total risk-weighted portfolio of loans for credit risk, given diversification.

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