The New Definition of Regulatory Capital

Laetitia Meneau, Emiliano Sabatini

This article was first published as a chapter in Basel III and Beyond on July 27, 2011, by Risk Books.

3.1 Introduction

Since the early 1980s, minimum capital requirements for banks have gained a pivotal role in financial regulation. With financial innovation and the input of international regulators, banking regulation evolved in most jurisdictions towards prudential approaches that allowed banks to carry out any type of financial business provided they were able to cover the corresponding risks by setting aside capital.

According to economic theory, the rationale for minimum capital requirements stems from the incentive structure entailed by banks’ safety-net systems. On the one hand, deposit insurance may give banks an incentive to increase risk, if the insurance premium is flat. On the other, since depositors are partially or fully insured, they have no incentive to monitor the bank. Therefore, requiring banks to hold minimum capital as a percentage of risk-adjusted assets prevents them from excessive risk taking. In addition, capital serves as a buffer against possible losses and thus banks’ default, externalities and contagion.

Obviously, to be fully effective