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Capital Requirements (Financial Institutions) Explained
Capital requirements is the minimum amount of funds that a bank or depositary institution is required to maintain or have on hand. The funds must not be claimed by anyone and are not obligated to be paid. In other words, it is reserved capital that cannot be lent to customers. This makes certain these funds are liquid and reserved to deal with unexpected losses that arise. Capital reserve requirements are set by the relevant regulatory agency, such as the Federal Reserve Bank, State Banking Regulators, the Federal Deposit Insurance Corporation, or the Bank for International Settlements.
A Little More on Capital Requirements
The basic concept behind requiring capital reserves is to make certain a bank has enough cash on hand to handle operational losses while still honoring all withdrawal requests. The capital requirements of a particular depositary institution is generally based upon the weighted risk associated with the types of assets held by the institution.
Capital requirements are generally used to calculate multiple ratios that are, in turn, used to evaluate a lending institutional financial strength and security. For example, a FDIC insured bank must have a “Tier 1” capital-to-risk weighted assets ratio of 4% of higher.
Many banks use the overnight lending program through the Federal Reserve Bank to lend the maximum amount of funds but maintain the minimum capital requirements.
The 2008 financial crisis lead to regulatory agencies raising the percentage of capital on hand to total assets for many banks and lending institutions.