Capital requirements are standardized regulations in place for banks and other depository institutions that determine how much liquid capital (that is, easily sold securities) must be held viv-a-vis a certain level of their assets.

Also known as regulatory capital, these standards are set by regulatory agencies, such as the Bank for International Settlements (BIS), the Federal Deposit Insurance Corporation (FDIC), or the Federal Reserve Board (the Fed).

An angry public and uneasy investment climate usually prove to be the catalysts for legislative reform in capital requirements, especially when irresponsible financial behavior by large institutions is seen as the culprit behind a financial crisis, market crash, or recession.

HOW THEY AFFECT BANKS ARE AS FOLLOWS -

Capital requirements aim not only to keep banks solvent but, by extension, to keep the entire financial system on a safe footing. In an era of national and international finance, no bank is an island as regulatory advocates note—a shock to one can affect many. So, all the more reason for stringent standards that can be applied consistently and used to compare the different soundness of institutions.

Pros

• Ensure banks stay solvent, avoid default

• Ensure depositors have access to funds

• Set industry standards

• Provide way to compare, evaluate institutions

FOR INSTANCE

Global capital requirements have swung higher and lower over the years. They tend to increase following a financial crisis or economic recession.

Before the 1980s, there were no general capital adequacy requirements on banks. The capital was only one of many factors used in the evaluation of banks, and minimums were tailored to specific institutions.

When Mexico declared in 1982 that it would be unable to service interest payments on its national debt, it sparked a global initiative that led to legislation such as the International Lending Supervision Act of 1983. Through this legislation and the support of major U.S., European and Japanese banks, the 1988 Basel Committee on Banking Regulation and Supervisory Practices announced that, for internationally active commercial banks, adequate capital requirements would be raised from 5.5% to 8% of total assets. It was followed by Basel II in 2004, which incorporated types of credit risk in the calculation of ratios.

However, as the 21^st century advanced, a system of applying a risk weight to different types of assets allowed banks to hold less capital with total assets. Traditional commercial loans were given a weight of 1. The one weight meant that for every $1 of commercial loans held on a bank's balance sheet, they would be required to maintain eight cents of capital. However, standard residential mortgages were given a weight of 0.5, mortgage-backed securities (MBS) issued by Fannie Mae or Freddie Mac were given a weight of 0.2, and short-term government securities were given a weight of 0. By managing assets accordingly, major banks could maintain lower capital ratios than before.

The global financial crisis of 2008 provided the impetus for the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Created to ensure that the largest U.S. banks maintain enough capital to withstand systematic shocks to the banking system, Dodd-Frank—specifically, a section known as the Collins Amendment—set the tier 1 risk-based capital ratio of 4% mentioned above. Globally, the Basel Committee on Banking Supervision released Basel III, regulations which further tighter capital requirements on financial institutions worldwide.