Some Aspects of Regulatory Capital
Financial Services Authority Occasional Paper No. 7
63 Pages Posted: 29 Oct 2003
Date Written: March 2000
This paper addresses three linked questions, in three separate sections.
The first section, "The Structure of Capital Requirements", asks what the purpose is of regulatory capital requirements for different types of financial services firms, and attempts to build a coherent theoretical framework to reflect the answer to that question. It starts from first principles on the basic rationale for regulation, and describes the various ways in which regulators can use capital requirements to help meet the objectives of regulation. It suggests a broad categorisation of financial services firms into four types, broadly aligned to the importance of preventing their failure, and the impact if failure were to occur. It then proposes different forms of capital requirement for each of those categories and discusses the appropriate mixture of capital with other tools of regulation.
The second section, "Setting Differentiated Capital Ratios", aims to shed light on the question of how capital can best be used as one of the tools of regulation. It describes the FSA's current approach to setting capital requirements for UK-incorporated banks, which involves specifying 'trigger' and 'target' capital adequacy ratios tailored to individual banks' risk profiles. It summarises how banks' current actual capital ratios compare with their target ratios set by the FSA, and discusses the reasons for the pattern seen. And it draws out the implications for initiatives to revise capital requirements for banks.
The third section, "Capital Requirements for Cross-Border Claims", looks at one example of the impact that capital requirements can have. From the Basel Committee's June 1999 proposals for reforming its Capital Accord, the paper takes the proposal that the risk-weighting of cross-border lending could be linked to the credit rating of the borrower's country of residence. Looking at the periods of crisis surrounding East Asia and Russia, this section estimates how the new proposals would have changed banks' capital requirements for lending to some major countries that underwent rating changes over the period. It attempts to shed some light on the question of 'procyclicality', the concern that increasing risk weights when a borrower is downgraded could add to the volatility of international capital flows. The paper finds that the amount of extra capital required by BIS-area banks in this case would have been very small compared to their total capital: it does not therefore provide strong support for concerns about procyclicality.
Keywords: Basel Accord, FSA, European Directives, regulation, Prudential Sourcebook, risk-asset ratio, trigger ratio, procyclicality
JEL Classification: L5
Suggested Citation: Suggested Citation