The Principles of Banking

Chapter 2

Bank Regulatory Capital

In Chapter 1 we noted the importance of capital to the basic business of banking. The ratio of a bank's capital to its overall balance sheet is a sign of the firm's overall health, and as the capital buffer is required to cover all losses suffered by the bank, it is the target of bank regulators' rulings. In this chapter we provide a primer on bank capital, its calculation, treatment and allocation. This includes a review of the standard Bank for International Settlements (BIS) regulatory capital rules, known as the Basel rules, to which all bank jurisdictions adhere to. We also introduce the main requirements of the Basel III rules. The second part of the chapter looks at the capital calculation and the concept of return on capital.

Bank Regulatory Capital

We review a topic of fundamental importance to bank ALM, that of regulatory capital and the Basel capital ratios. The cost of capital is the driver behind return on capital calculations, and a prime objective of banking operations is to meet return on capital targets. Hence, regulatory capital issues play an important part in bank strategy.

The need for adequate regulation of the banking industry is widely recognised, and a string of banking failures in the 1990s emphasised this. Lessons were not learned, however, as capital inadequacy was again an issue during the “credit crunch” of 2007–2008.

By the nature of their activities, bank trading and lending desks are risk-takers, and the reward ...