An Analysis on the Different Capital Constraints Faced by Banks

Introduction

The global financial crisis of 2007-09 led to unprecedented change in regulatory capital requirements under Basel III, forcing financial institutions to hold more high-quality liquid assets and reserves against their riskier loan and trading books. Beyond this, it introduced a more sophisticated methodology for calculating capital requirements with the aim of better capturing systemic risk; the downside being an increased regulatory burden on the banking system.

In spite of these costs, an intimate knowledge of banking regulation can allow financial institutions to strategically manage and optimise their lending & trading decisions with an eye to the impacts on capital. This concept of capital optimisation, along with tools such as compression, allow financial institutions to better assess and manage their regulatory obligations, leading to lower capital requirements and higher returns.

Capital Constraints Faced by Financial Institutions

Under Basel III, the capital held by financial institutions is subdivided into Tier 1 and Tier 2 capital; this is capital designed to absorb unexpected loses encountered from their various business segments. These tiers of capital are comprised of:

• Common Equity Tier 1 (CET1) – Common equity, retained earnings and noncumulative preferred shares.
• Additional Equity Tier 1 (AT1) – Hybrid securities, such as contingent convertible bonds, cumulative preferred shares.
• Tier 2 Capital – Loan-loss provisions, subordinated debt.

The requirements under Basel III for financial institutions can be broadly categorised as direct constraints on capital ratios or indirect constraints through leverage, margin, etc.

Direct Costs and Constraints – Risk Weighted Assets (RWAs)

Under Basel III, a bank’s assets and off-balance sheet exposures are included in determining their risk-weighted assets, which are used to determine capital requirements, subject to minimum CET1, Tier 1 and total capital ratios[1].

It is worth noting that institutions that qualify as Global-Systemically Important Banks (G-SIBs) are subject to more stringent capital requirements under this framework[2]. For an institution with an active trading business in derivatives, the following risk classes apply in the RWA calculation:

1. Counterparty Credit Risk – the risk of default by the participant on the other side of the derivative trade. This is calculated under the SA-CCR framework taking into account Exposure at Default (EAD).
2. Market Risk – the risk of loses arising from movements in market prices, calculated under the FRTB standardised approach[3] – includes default, interest rate, credit spread, equity, commodity and FX risk.
3. Operational Risk – loses stemming from “inadequate or failed internal processes, people and systems or external events”. Calculated using the Standardised Measurement Approach – taking business segment and gross income into account.

Indirect Costs and Constraints – non-RWAs 

Alongside the RWA capital constraints above, financial institutions must also ensure compliance with:

1. Minimum Leverage Ratio – indicates the amount of capital on hand to cover loses emerging from on/off balance sheet, with addons for exposure to derivatives and security financing transactions.
2. Leverage Ratio Buffer for G-SIBs – the minimum leverage ratio is increased for G-SIBs by a set amount[4].
3. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) – metrics preventing overreliance on short-term funding with the hope of preventing forced liquidations if short-term lending markets freeze.
4. Uncleared Marin Rules (UMR) – firms trading uncleared derivative with IM exceeding $50 million must post IM based on ISDA’s SIMM methodology.

[1] These are ratios of the various tiers of capital described above to risk weighted assets (RWAs) – these being the bank’s assets and exposures weighted by risk profile.

[2] Designation and consequences of G-SIBs is explained in detail in “G-SIBs – Compression and Reducing Notional” Link to Article III

[3] FRTB or the Fundamental Review of the Trading Book is the set of regulations governing the determination and scope of capital requirements relating to market risk.

[4] Note that this measure is expected to take effect in 2023 under the Basel 3.1/4 Accords.

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