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Economic Analysis of Financial Regulation - Types of financial regulation - Capital requirements

7 important questions on Economic Analysis of Financial Regulation - Types of financial regulation - Capital requirements

What are capital requirements?

Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions

Which two capital requirement are there?

1. Leverage ratio
2. Risk-based requirements

What is the leverage ratio?

Minimum leverage ratio (for banks) (Before the 1980s) Based on the leverage ratio, the amount of capital divided by the bank’s total assets: to be classified as well capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank.

Explain the different risk-based capital requirements

min 8% risk-weighted assets as capital
• Little default risk: government securities from OECD countries (0%)
• Claims on banks in OECD countries (20%)
• Municipal bonds and residential mortgages (50%)
• Loans to consumers and corporations (100%)

What is regulatory arbitrage?

Banks keep on their books assets that have the same risk-based capital requirement but are relatively risky

Explain the three pillars which basel 2 is based on

•Pillar 1 links capital requirements for large, internationally active banks more closely to actual risk of three types: market risk, credit risk, and operational risk.

• Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and evaluating whether these institutions have adequate procedures in place for determining how much capital they need.

• Pillar 3 focuses on improving market discipline through increased disclosure of details about a bank’s credit exposures, its amount of reserves and capital, the officials who control the bank, and the effectiveness of its internal rating system.