Capital Requirements – Definition

Cite this article as:"Capital Requirements – Definition," in The Business Professor, updated March 8, 2019, last accessed May 27, 2020, https://thebusinessprofessor.com/lesson/capital-requirements-definition/.

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Capital Requirements Definition

The least amount of money that banks and depository institutions are required to maintain is referred to as capital requirement. This amount should never be claimed, should never be lent and should not be on debt. The reserved capital is meant to deal with unexpected losses. This amount is set by Federal Reserve Bank, Federal Deposit Insurance Corporation, State Banking Regulators and Bank for International Settlements.

A Little More on What are Capital Requirements

Banks are required to maintain capital reserves to ensure that they have enough cash to handle unexpected losses while still honoring customers’ withdrawal requests. To set capital requirements for an institution, the concerned authorities consider the weighted risks linked with the investments and assets of the depository institution.

Capital requirements are key in evaluating the security and financial strengths of lending institutions. For instance, a bank insured with FDIC is required to have a Tier-1 capital-to-risk ratio. Most banks are able to lend the maximum amount of funds and maintain the minimum capital requirement through the overnight lending program.

After the financial crisis of 2008, regulatory agencies raised the minimum capital requirements for banks and creditors.

References for Capital Requirements

Academic Research on Capital Requirements

  • Liberalization, moral hazard in banking, and prudential regulation: Are capital requirements enough?, Hellmann, T. F., Murdock, K. C., & Stiglitz, J. E. (2000). American economic review, 90(1), 147-165.  This paper looks at the effect that capital requirements have on bank behavior. Competition between banks has undermined banking best practices but sanity has been brought back by having capital requirements. While capital requirements have reduced the probability of banks gambling with their equity, they have also harmed the franchise value of banks.
  • Do capital adequacy requirements reduce risks in banking?, Blum, J. (1999). Journal of Banking & Finance, 23(5), 755-771. This paper looks at the effects of capital requirements in banks. It observes that with increased capital requirements, the riskiness of a bank is increased. Most banks find it challenging to increase their equity and as such, they increase their risks today to enhance their chance of increasing equity.
  • Bank portfolio allocation: The impact of capital requirements, regulatory monitoring, and economic conditions, Furfine, C. (2001). Journal of Financial Services Research, 20(1), 33-56. This research looks at the impact that capital requirements have on banks’ loan portfolios. The paper looks at how banks experience capital shocks, unexpected loan demands and other costs due to their proximity to the minimum capital requirements. It further goes to research on the responses of banks to increased capital requirements, increase monitoring intensity and economic downturns.
  • Capital requirements and bank behaviour: Empirical evidence for Switzerland, Rime, B. (2001). Journal of Banking & Finance, 25(4), 789-805.  This paper delves deep into the behavior of banks with increasing capital requirements. The research pays attention to Swiss banks and their response to the constraints placed by capital requirements and other set regulations. In conclusion, the paper observes that while capital requirements and other regulatory pressures have made banks increase their capital, they have not affected the level of risk of banks.
  • Simulation based stress tests of banks’ regulatory capital adequacy, Peura, S., & Jokivuolle, E. (2004). Journal of Banking & Finance, 28(8), 1801-1824. This paper looks at how banks determine the sufficient buffer size in their management of risk. It further looks at how banks maintain their capital under the current regime and how they do so under Base II.
  • Capital requirements, monetary policy, and aggregate bank lending: theory and empirical evidence, Thakor, A. V. (1996). The Journal of Finance, 51(1), 279-324. This paper looks at capital requirements in relation to banks’ lending behavior. The paper observes that, the decision of a bank to lend will lead to a an abnormal borrower’s stock price runup. This research shows further how the Federal Reserve Bank has not been able to stimulate lending by increasing capital requirements.
  • The cyclical effects of the Basel II capital requirements, Heid, F. (2007). Journal of Banking & Finance, 31(12), 3885-3900.  This paper looks at the roles of capital requirements at regulating banks. While the regulations are changing to introduce sensitive capital charges, there is fear that capital requirements are limiting the ability of banks to lend and this might cause an economic downturn.
  • Regulation of bank capital and portfolio risk, Koehn, M., & Santomero, A. M. (1980). The journal of finance, 35(5), 1235-1244. This paper looks at how bank capital affects its portfolio risk. As banks work to increase their capital and maintain capital requirements, their ability to acquire assets and enter into investments is affected.
  • Capital requirements, market power, and risk-taking in banking, Repullo, R. (2004). Journal of financial Intermediation, 13(2), 156-182.  This paper looks at how banks are engaged in imperfect competition which has led to banks investing in prudent or gambling assets. In instances where intermediation margins are small, the franchise of the bank will be small and this can lead the bank to gambling assets.
  • The macroeconomic implications of capital adequacy requirements for banks, Blum, J., & Hellwig, M. (1995). European Economic Review, 39(3-4), 739-749. This paper looks at how capital adequacy regulations affect world economics. The paper reviews the economics of Europe and how bank regulations have affected the economy.
  • Capital regulation and bank risk-taking: A note, Furlong, F. T., & Keeley, M. C. (1989). Journal of banking & finance, 13(6), 883-891.  This paper looks at how stringent regulations in the banking sector are affecting the asset portfolio risk of banks. It goes further to show that for value-maximizing banks, the motivation to increase asset risk reduces as its capital increases.

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