The Baseline Scenario is an excellent site which explains global economic issues and digs deep into policy decisions and the long-term reprocussions of those decisions on economies and markets.  The authors; Peter Boone, Simon Johnson, and James Kwak are all accomplished professionals, and I truly enjoy reading their work.  Below is a sample of one of their recent articles on Regulatory Capital for Banks:

Regulatory Capital Arbitrage for Beginners

 

Regulatory capital refers to the amount of capital a financial institution must hold because of regulatory requirements. Capital is the amount of value in a bank that is attributable to the shareholders – that is, the bank’s assets minus its liabilities. There are different kinds of capital, but we can ignore that here.

One function of capital – the function that regulators care about – is to insulate banks from losses. Assets can fluctuate in value; a borrower can owe you $100, but if he goes bankrupt and flees the country, that loan is worth zero. The amount of your liabilities does not fluctuate, however. If you have $100 in assets, $90 in liabilities, and $10 in capital, then you can withstand a 10% fall in the value of your assets and still pay off your debts; if you have $98 in liabilities and $2 in capital, then a 3% fall will make you insolvent (unable to pay off your debts).

Regulators impose capital requirements in order to help ensure the safety and soundness of banks. There are various reasons why safe and sound banks are good, but the most direct – from the regulator’s perspective – is that the government is insuring the bank’s liabilities; for example, the FDIC now insures deposits up to $250,000 per person. Since the government is on the hook if the bank becomes insolvent, it wants to reduce the chances of that happening – hence capital requirements.

The question is how much capital should be required, and the key concept is risk-based capital. The idea is that some assets are riskier than others. If you hold very safe assets, like cash or short-term U.S. Treasury bills, then the chances of even a 3% fall in value are miniscule, so you shouldn’t need to hold much capital. However, if you hold risky assets, like loans to build offshore drilling platforms in the Arctic Ocean, then you should have to hold more capital.

The theory is simple. Every asset has a certain amount of risk; a firm that holds that asset should also hold, for that asset, an amount of capital proportional to its risk. Both on the firm level and on the system level, then, capital levels will adequately insure against the risk of losses. The tricky thing is putting this into practice, for two reasons: first, it’s impossible a priori to know how risky a given asset is (you can only estimate it); second, the potential complexity of financial transactions far exceeds the ability of regulators to specify rules for every one.

 

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