Economic Commentary
- Jan-Peter Siedlarek
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Following the Global Financial Crisis of 2007–2008, the capital standards for banks operating in the United States were tightened as US banking regulators implemented the Basel III framework. This Economic Commentary briefly presents the key elements of Basel III relevant to bank capital and analyzes the timing of the evolution of regulatory capital ratios for US bank holding companies during that time. It shows that, on average, banks’ capital ratios increased notably between 2009 and 2012, plateauing before the new rules came into force. While larger and better-capitalized banks increased capital ratios soon after the financial crisis, it took smaller and less-well-capitalized banks longer on average to start that process.
Topics
Bank policy and regulation
Financial policy and implementation
Financial crises
03.26.2024ISSN 2163-3738EC 2024-07DOI 10.26509/frbc-ec-202407
The views authors express in Economic Commentary are theirs and not necessarily those of the Federal Reserve Bank of Cleveland or the Board of Governors of the Federal Reserve System. The series editor is Tasia Hane. This paper and its data are subject to revision; please visit clevelandfed.orgfor updates.
Introduction
Bank capital standards are a key pillar of modern banking regulation. They require banks to operate with a minimum amount of capital relative to the loans, securities, and other assets on their balance sheets. This capital, mostly in the form of shareholder equity, is first in line in case of losses, for example, from loan defaults, and thereby provides a cushion to protect depositors and other debt holders in the bank. Shortfalls in bank capital were seen as a contributing factor to the financial crisis of 2007–2008 and the subsequent major recession. In response, regulators across the world sought to tighten regulation following this financial crisis to help prevent future similar crises. These efforts included a tightening of bank capital regulation, requiring banks to hold both more and higher-quality capital, thereby increasing the resilience of the banking system. More recently, following the failures of Silicon Valley Bank and other banks in March 2023, bank capital regulation has once again been under scrutiny, and a new reform package modifying capital requirements, known as “Basel III endgame,” has been proposed by US bank regulators.1
This Economic Commentary presents the evolution of banks’ regulatory capital ratios around the introduction of higher capital requirements that were part of the post-financial crisis Basel III reforms, analyzing the path of capital ratios across groups of different sizes and across the distribution of tier 1 capital ratios both before and after the introduction of this framework. This analysis of capital ratios around an earlier episode of increased capital requirements can be informative for thinking about banks’ possible responses to new capital regulations.
The Tightening of Capital Requirements after 2008 under Basel III
Going into the financial crisis, regulatory capital requirements for banks operating in the United States were based on the Basel II framework published by the Basel Committee on Banking Supervision (BCBS) in 2004. This framework maintained the two main minimum capital ratios of the earlier Basel I framework, first published by the BCBS in 1988: (1) tier 1 capital to risk weighted assets (RWA) of at least 4 percent, and (2) total capital to RWA of at least 8 percent.2 Following the financial crisis of 2007–2008, the regulatory requirements in Basel I and Basel II were widely regarded by banking regulators as deficient, and there was a concerted international effort to strengthen banking regulation, a process which resulted in the Basel III framework published in September 2010 by the BCBS.
Among other elements of tightening banking regulation, Basel III strengthened minimum capital requirements in several ways.3 First, it introduced a new, narrower category of capital called “common equity tier 1” (CET1) capital with a minimum CET1 capital-to-RWA ratio requirement of 4.5 percent. CET1 capital presents the highest quality regulatory capital, able to absorb losses as they occur. The CET1 measure comprises mostly common stock and retained earnings and does not include the additional instruments that are permitted under the less strict tier 1 capital measure.
Second, Basel III tightened the minimum tier 1 capital ratio, both narrowing what banks could count toward tier 1 capital relative to previously and increasing the existing minimum tier 1 capital-to-RWA ratio from 4 percent to 6 percent. Third, under Basel III, banks are expected to build up various capital buffers on top of these strict minimums, including the capital conservation buffer (CCB) of 2.5 percent applicable to all banks and an additional surcharge for the “global systemically important banks” (G-SIB), the very largest and systemically important institutions.4 The new capital buffers on top of the minimum capital requirements are meant to provide an additional layer of protection and act as an early warning mechanism. A failure to meet the required buffer levels leads to restrictions on payouts, such as dividends and bonuses, and thereby helps to keep earnings within the bank.
In the United States, the Basel rules were implemented by the financial sector regulators including the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). A proposed rule was published in June 2012 and, following a comment period, the final rule was released in July 2013. The new regulatory capital minimums became binding for most banks on January 1, 2015, while the additional CCB and G-SIB buffers were phased-in between 2016 and 2019, as shown in Figure 1.5 In terms of the minimum tier 1 capital ratio, the new rules implied a jump from 4 percent to 6 percent by 2015, increasing for most banks to 8.5 percent including the capital conservation buffer by 2019, with an additional G-SIB surcharge on top for some of the largest banks.