A Law and Finance Approach
Chapter 5: Regulatory capital
that preceded the crisis. Since the 1980s the locus of regulatory capital policy shifted from domestic prudential authorities to a multilateral forum dominated by central banks and treasuries of the major financial powers. Coordinated by the Basel Committee for Banking Supervision (BCBS) of the Bank for International Settlements, this forum has developed a standard regulatory approach designed to shore up bank funding. Though focused first on the credit risk in bank asset holdings, the approach has since expanded to provision for interest rate risk, price risk, equity volatility and, after the crisis, the bank’s funding liquidity risk. Intended originally for internationally active banks, the same approach has come to apply to most depository operations.As analyzed below, the approach involves the construction of a regulatory balance sheet that reflects prudential adjustments to how the bank measures its financial condition. This exercise promotes loss-absorption by requiring the bank to hold equity capital (defined by regulation) proportionate to the risk of loss in the bank’s assets, as measured by regulators’ policy judgments about asset quality. By requiring these minimum equity contributions, these policy judgments impose a leverage constraint on the bank, which must raise and maintain enough balance sheet equity to meet capital requirements.As the BCBS rules underwent modification and expansion, regulators gave banks increasing levels of discretion to determine their own capital adequacy. As measured by their reports of regulatory capital, U.S. banks seemed to have adequate levels of loss-absorbing capital in the years leading up to the crisis. However, the bank...
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