Capital Adequacy Ratio 2017: A Guide to Basel III and Basel IV Changes

In 2017, the Basel Committee on Banking Supervision made significant changes to the Capital Adequacy Ratio, a key metric used to assess a bank's financial health. The changes, outlined in the Basel III framework, aimed to strengthen banks' capital positions and improve their ability to absorb losses.

The minimum Common Equity Tier 1 (CET1) ratio was raised to 4.5% from 4% to ensure banks have sufficient capital to cover potential losses. This increase was phased in over several years, with a 2.5% minimum required by 2019 and the full 4.5% by 2022.

Banks were also required to hold a minimum amount of capital against their risk-weighted assets, with a 10% minimum required for the first 1% of risk-weighted assets and 15% for the next 9%. This change aimed to reduce the risk of banks holding too much low-quality assets.

The Basel III framework also introduced a new liquidity requirement, which mandated that banks hold a minimum amount of liquid assets to meet their short-term obligations. This requirement was set at 100% of a bank's net cash outflows over a 30-day period.

A Call Report is required to be filed with the FDIC. This report provides crucial information about an institution's total consolidated assets, which is used to determine whether it meets the capital adequacy ratio requirements.

An FDIC-supervised institution with total consolidated assets of $50 billion or more as reported on its most recent year-end Call Report must comply with specific public disclosure requirements. These requirements are outlined in sections 324.61 through 324.63 of the subpart.

To determine total consolidated assets, the FDIC-supervised institution calculates the average of its total consolidated assets in the four most recent quarters as reported on the Call Report. This average is used to determine whether the institution meets the capital adequacy ratio requirements.

The Capital Adequacy Ratio is a measure of a bank's ability to absorb potential losses. It's a crucial metric for lenders and regulators alike.

A Capital Adequacy Ratio is calculated by dividing a bank's capital and reserves by its risk-weighted assets. This ratio is often expressed as a percentage.

In simple terms, a higher Capital Adequacy Ratio means a bank has more buffer to absorb potential losses. This is a good thing for depositors and investors who want to see their money safe.

Regulators require banks to maintain a minimum Capital Adequacy Ratio, which varies by country and jurisdiction. This ensures that banks have enough capital to cover potential losses and maintain stability in the financial system.

The Capital Adequacy Ratio is closely tied to a bank's risk management practices and its ability to manage credit risk, market risk, and operational risk.

The purpose of the Capital Adequacy Ratio is to ensure that banks have enough capital to absorb losses and maintain stability. This is crucial because banks play a vital role in the economy, and their failure can have far-reaching consequences.

The Capital Adequacy Ratio is a regulatory requirement that measures a bank's ability to absorb potential losses. It's a percentage that represents the bank's capital relative to its risk-weighted assets.

A higher Capital Adequacy Ratio indicates that a bank has a stronger financial position and can better withstand potential losses. This is because the ratio shows that the bank has more capital to absorb losses, making it less likely to fail.

Banks with a lower Capital Adequacy Ratio are considered riskier and may face stricter regulations or even be forced to merge with other banks. This is because they have less capital to absorb losses, making them more vulnerable to failure.

The Basel III agreement raised the minimum CET1 capital ratio to 4.5% and the minimum Tier 1 capital ratio to 6%. The total amount of reserve capital must be over 8%.

Basel IV standards, adopted in 2017, started taking effect in January 2023, and fine-tune the calculations of credit risk, market risk, and operations risk.

These changes aim to enhance the banking system's stability and resilience, particularly in the wake of the 2007-8 financial crisis.

Basel III was a major overhaul of the banking system's capital requirements. The Basel Committee met in 2010 to address the weaknesses exposed by the 2007-8 financial crisis.

The Basel III agreement raised the capital requirements and introduced more-stringent disclosure requirements. It also introduced the distinction between Tier 1 and Tier 2 capital.

The minimum CET1 capital ratio was set at 4.5%, and the minimum Tier 1 capital ratio (CET1 + AT1) was set at 6%. The total amount of reserve capital (Tier 1 and Tier 2) must be over 8%.

These standards were a significant increase from the original Basel I agreement, which had a minimum capital ratio of 8%.

Basel IV is a set of recommendations adopted in 2017 that started taking effect in January 2023. These recommendations focus on fine-tuning calculations of credit risk, market risk, and operations risk.

The Basel IV standards enhance the leverage ratio framework for certain banks, making it a crucial update for financial institutions.

An FDIC-supervised institution must make public disclosures described in subpart F of part 324.

From January 1, 2015 to December 31, 2017, an advanced approaches FDIC-supervised institution is not required to maintain a supplementary leverage ratio.

Total risk-weighted assets for equity exposures are calculated under §§ 324.52 and 324.53.

The FDIC-supervised institution must apply risk weights to its exposures as follows: determine the exposure amount of each on-balance sheet exposure.

The risk-weighted asset amount for each exposure is determined by multiplying the exposure amount by the risk weight appropriate to the exposure.

The total risk-weighted assets for general credit risk equals the sum of the risk-weighted asset amounts calculated under this section.

An FDIC-supervised institution's dollar risk-based capital requirement for operational risk is its operational risk exposure minus eligible operational risk offsets (if any).

The FDIC-supervised institution's risk-weighted asset amount for operational risk equals the FDIC-supervised institution's dollar risk-based capital requirement for operational risk multiplied by 12.5.

To calculate your risk-weighted assets for general credit risk, you need to determine the exposure amount of each on-balance sheet exposure, OTC derivative contract, and off-balance sheet commitment. This includes transactions that are not unsettled, cleared, default fund contributions, securitization exposures, or equity exposures.

The risk weight for each exposure is determined by multiplying the exposure amount by the risk weight appropriate to the exposure type or counterparty. This is a crucial step in calculating your total risk-weighted assets for general credit risk.

Your total risk-weighted assets for general credit risk equals the sum of the risk-weighted asset amounts calculated under this section.

Components play a crucial role in any calculation, and understanding them is essential for accuracy.

A component is a basic building block of a calculation, and there are several types, including constants, variables, and functions.

Constants are values that don't change, such as pi or the square root of 2.

Variables, on the other hand, are values that can change, such as x or y.

Functions are operations that take one or more inputs and produce an output, like addition or subtraction.

In a calculation, components can be combined in various ways to produce a result.

For example, if you're calculating the area of a circle, the component for the radius would be a variable, while the component for pi would be a constant.

Functions can also be used to simplify complex calculations, making them easier to understand and solve.

To calculate risk-weighted assets, FDIC-supervised institutions must apply risk weights to their exposures based on the exposure type or counterparty.

An institution must determine the exposure amount of each on-balance sheet exposure, OTC derivative contract, and off-balance sheet commitment, trade and transaction-related contingency, guarantee, repo-style transaction, financial standby letter of credit, forward agreement, or other similar transaction.

Exposures that are unsettled transactions, cleared transactions, default fund contributions, securitization exposures, or equity exposures are exempt from this requirement.

Risk-weighted asset amounts are calculated by multiplying each exposure amount by the risk weight appropriate to the exposure.

The total risk-weighted assets for general credit risk equals the sum of the risk-weighted asset amounts calculated under this section.

For sovereign exposures, specific rules apply, but the article doesn't provide further details on these rules.

Banks were required to maintain a minimum capital adequacy ratio of 8% in 2017, as stated in the Basel III framework.

The Basel III framework also introduced a new leverage ratio requirement, which requires banks to have a minimum leverage ratio of 3%.

This leverage ratio was designed to prevent banks from excessive leverage and ensure they have sufficient capital to absorb potential losses.

To be eligible for regulatory compliance, businesses must meet certain criteria.

The Federal Trade Commission (FTC) defines a business as a for-profit entity that engages in commerce.

Businesses must be registered with the Secretary of State in the state where they operate.

The FTC requires businesses to have a physical presence, such as an office or warehouse, in the state where they operate.

A business must also have a legitimate business purpose, such as selling a product or service.

The FTC considers a business to be legitimate if it has a reasonable expectation of profit.

Businesses that are not for-profit, such as non-profits or charities, are generally exempt from regulatory requirements.

As an FDIC-supervised institution, you're required to provide timely public disclosures each calendar quarter of your capital adequacy and risk profile.

These disclosures must be made in the applicable tables in § 324.63, and any significant changes must be disclosed as soon as practicable.

If a significant change occurs, you'll need to provide a brief discussion of the change and its likely impact.

Qualitative disclosures that don't change often, such as a general summary of your risk management objectives and policies, can be disclosed annually.

However, any significant changes must be disclosed in the interim.

You'll need to provide all of the disclosures required in one place on your public Web site or in more than one public financial report or regulatory report, as long as you publicly provide a summary table indicating the location(s) of all such disclosures.

Your board of directors must approve a formal disclosure policy that addresses your approach for determining the disclosures you make.

This policy must also address internal controls and disclosure controls and procedures.

One or more senior officers must attest that the disclosures meet the requirements of this subpart.

If you conclude that specific commercial or financial information would be exempt from disclosure by the FDIC under the Freedom of Information Act, you're not required to disclose that specific information.

Instead, you must disclose more general information about the subject matter of the requirement, along with the reason why the specific information has not been disclosed.

Qualification is a crucial aspect of regulatory requirements, and it's essential to understand what's expected of you. An FDIC-supervised institution must meet all qualification requirements in § 324.122 on an ongoing basis.

To maintain qualification, institutions must notify the FDIC of any changes to advanced systems that would result in a material change in their advanced approaches total risk-weighted asset amount for an exposure type. This includes significant changes to modeling assumptions.

Institutions that fail to comply with qualification requirements will be notified in writing by the FDIC and must establish a plan to return to compliance. The FDIC may also require institutions to recalculate their advanced approaches total risk-weighted assets with any modifications provided.

To incorporate operational risk mitigants, institutions must have an operational risk quantification system that can generate two estimates: one with and one without mitigants. This allows institutions to adjust their estimate of operational risk exposure to reflect qualifying operational risk mitigants.

Qualifying operational risk mitigants include insurance provided by an unaffiliated company with strong capacity to meet claims payment obligations and a PD equal to or less than 10 basis points. The insurance must also have a minimum term of one year, a residual term of more than 90 days, and a 90-day notice period for cancellation.