Financial Update (July-September 1998)

Masthead

Cover Story

Choice of Capital Instruments

New Look for Financial Update

Check Growth

Bank Consolidation and Lending

Technology in Banking

DEPARTMENTS

Year 2000

Did You Know?

Data Bank

The Docket

Did You Know?

Risk-Based Standards For
Capital Requirements

B eginning in the early 1990s, the Federal Reserve and other organizations that regulate depository institutions implemented requirements that institutions maintain a certain level of capital based on the risk of asset loan portfolios or liabilities.

These risk-based standards were developed to ensure that depository institutions would have sufficient capital to recover any unforeseen or excessive losses and thus to reduce the probability of a bank failure and losses to the Federal Deposit Insurance Corporation (FDIC) if a bank should fail.

Recently, there has been considerable discussion of how to ensure these standards remain relevant in evaluating and regulating today's more sophisticated and complex depository institutions. Examining the current risk-based capital standards and some of the criticisms of the standards provides some perspective on this discussion.

A Historical View

In the 1970s, there were no formal numeric standards for determining an institution's capital requirements. Regulators used rules of thumb and portfolio analysis to set capital requirements to protect an institution's depositors, its deposit insurer or the financial stability of other institutions.

With risks increasing through deregulation, innovation, inflation and growing competition in the financial industry, the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency began to implement capital standards in 1981 that set minimum capital-to-total-asset ratios for all banks. Although the 1981 standards encouraged higher capital as intended, they also had the unintended effect of encouraging institutions to reduce their holdings of low-risk/low-return assets and increase their exposure through contracts that were not reported as assets on their balance sheet, such as standby letters of credit.

In 1988, bank regulators from the Group of Ten countries adopted risk-based capital standards in the form of the Basle Accord, which classifies assets and off-balance-sheet activities based on credit risks. These standards — officially put into effect in the United States in 1992 — require institutions to have sufficient capital to cover the estimated credit risks inherent in their balance sheets and off-balance-sheet activities. For example, the standards require institutions to back, with a specified proportion of capital, 100 percent of their loans to businesses and individuals except for residential mortgage loans, which are weighted at 50 percent. Risk-weighting values are also used for other types of assets.

In 1996, market risk was added to the standards. In evaluating this risk, regulators now allow institutions to monitor and evaluate themselves using the institution's proprietary internal risk model. The market-risk standard applies to the large banks.

Criticisms of the Current Risk-Based System

While they have helped increase the capital levels of depository institutions, risk-based standards are not without criticism. For example, some institutions claim that the capital standards are too severe and affect their ability to compete with unregulated, nonbanking financial institutions. Another criticism is that big and small institutions are evaluated using the same scale even though their credit risks may not behave in the same way.

More recent criticism centers on the argument that the risk-based system currently in place is less sophisticated than the current practices of some of the largest and most advanced depository institutions. In fact, some analysts contend that the current risk-based capital requirements are distorting depository institutions' decisions on how to determine capital needs and are not necessarily contributing to the safety and soundness of the organization.

For the Future

There is growing support for continuing to evaluate the current risk-based capital standards to ensure that they meet today's and tomorrow's challenges and complexities as depository institutions become larger through consolidation and their financial practices become more complex.

One suggestion is that regulators tailor their approach to supervising depository institutions' credit risk to more closely match the sophistication level of each institution's portfolio management and its credit risk measurement systems. Large banks could use techniques similar to those they now use to evaluate market risks. (For a survey of credit risk models and a discussion of their possible uses in the supervisory process, see the report of Credit Risk Models at Major U.S. Banking Institutions on the Federal Reserve Board's World-Wide Web site at http://www.federalreserve.gov/boarddocs/creditrisk.)

While the current standards do have merit, regulators generally agree that the risk-based standards should and will continually be evaluated to ensure safety and soundness in the banking system. It remains to be seen what changes will be made as a result of this ongoing evaluation.