Regulatory capital is the amount of capital that a Globally Systemically Important Bank (G-SIB) is required to hold in order to cover unexpected losses. It acts as a cushion to absorb losses and protect depositors' funds. It is important because it ensures that banks have enough financial resources to continue operating even during times of financial stress. There are two types of regulatory capital: Tier 1 and Tier 2.
Tier 1 capital is the core capital of a bank, which includes equity and retained earnings. Tier 2 capital is the secondary capital, which includes subordinated debt and other hybrid instruments, such as AT1 bonds, which have received much media attention recently following the Credit Suisse failure. The total regulatory capital is the sum of Tier 1 and Tier 2 capital.
Liquidity: Definition and Importance
Liquidity is the ability of a bank to meet its financial obligations as they fall due. It is important because it ensures that a bank can continue to operate and meet the demands of its customers. There are two types of liquidity: funding liquidity and market liquidity.
Funding liquidity is the ability of a bank to raise funds in the short term to meet its financial obligations. Market liquidity is the ability of a bank to sell its assets quickly without affecting their market price. Banks need to have both types of liquidity to operate effectively.
Regulatory Frameworks for Capital and Liquidity
PRA Framework: The Prudential Regulation Authority (PRA) is the UK's primary regulator of banks, building societies, credit unions, and insurers. Its regulatory framework for regulatory capital and liquidity is based on the Basel II and III frameworks. The PRA requires banks to hold a minimum level of regulatory capital, which is expressed as a percentage of risk-weighted assets. It also requires banks to maintain a minimum level of liquidity, which is measured by the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).
EBA Framework: The European Banking Authority (EBA) is a regulatory agency of the European Union (EU). Its regulatory framework for regulatory capital and liquidity is based on the Capital Requirements Directive (CRD) IV. The EBA requires banks to hold a minimum level of regulatory capital, which is also expressed as a percentage of risk-weighted assets. It also requires banks to maintain a minimum level of liquidity, which is measured by the LCR and the NSFR.
CRD IV Framework: The CRD IV is a regulatory framework for banks in the EU. It sets out the minimum requirements for regulatory capital and liquidity. The framework requires banks to hold a minimum level of regulatory capital, which is expressed as a percentage of risk-weighted assets. It also requires banks to maintain a minimum level of liquidity, which is measured by the LCR and the NSFR.
Basel II Framework: Basel II is an international regulatory framework for banks. It sets out the minimum requirements for regulatory capital and liquidity. The framework requires banks to hold a minimum level of regulatory capital, which is measured using a standardized approach or an internal ratings-based approach. It also requires banks to maintain a minimum level of liquidity, which is measured by the LCR and the NSFR.
Basel III Framework: Basel III is an updated version of the Basel II framework, which was introduced in response to the 2008 global financial crisis. It includes additional requirements for regulatory capital and liquidity. The framework requires banks to hold higher levels of Tier 1 capital, which includes Common Equity Tier 1 (CET1), to strengthen their capital position. It also requires banks to maintain a minimum level of liquidity, which is measured by the LCR and the NSFR.
Differences between the Frameworks
Although the frameworks are similar in many respects, there are some differences between them. For example, the PRA requires UK banks to maintain a higher level of CET1 capital than the EBA or Basel III frameworks. The EBA framework also includes additional requirements for liquidity risk management and stress testing.
Challenges and Criticisms
One of the main challenges of regulatory capital and liquidity frameworks is that they can be complex and difficult to understand. This can make it difficult for smaller banks to comply with the requirements, and can also make it difficult for regulators to enforce them effectively.
There have also been criticisms that the frameworks do not go far enough in protecting depositors' funds and ensuring the stability of the financial system. Some critics argue that the requirements for regulatory capital and liquidity should be even higher to prevent future financial crises.
Conclusion
In conclusion, regulatory capital and liquidity are essential components of the banking industry. The frameworks developed by the PRA, EBA, CRD IV, Basel II, and III play a critical role in ensuring the stability and safety of banks, protecting depositors' funds, and maintaining public confidence in the financial system. While the frameworks are similar in many respects, there are some differences between them, and challenges and criticisms remain. Nonetheless, they represent an important step forward in strengthening the resilience of the financial system.
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About the author
Sabbir Rahman is Managing Director of Langdon Capital. He has held prior roles with Morgan Stanley, Lazard and Barclays Investment Bank. He has executed over £60 billion in notional value of transactions across financing, M&A and derivatives with global corporates, private equity funds and financial sponsor groups.
About Langdon Capital
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