Bank Capital and Its Regulations

Regulatory guidelines define capital and acceptable capital levels for banks, using a risk-based approach that converts a bank’s assets including off-balance sheet items, to risk-equivalent assets. For a sample calculation of risk-weighted assets, click on “Learn More” for that topic. The purpose of these guidelines is to increase depositor protection, protect the deposit insurance fund, and establish global capital standards for banks. Capital levels are also used to set limits on certain bank actions, such as investment in bank premises, loans to an individual borrower, and the maximum amount of dividends a bank may pay.

The risk-based capital regulations divide capital into two groups:

  • Tier 1, or core, capital is similar to what is normally thought of as capital in other businesses. Click to view examples. You might also hear Tier 1 referred to as “hard” capital.
  • Tier 2, or supplemental, capital consists of such things as: Click to view examples. Tier 2 capital is subject to some limits.

The sum of Tier 1 and Tier 2 capital, less certain deductions, represents a bank’s total capital. In the capital regulations, Tier 1 capital must constitute at least 50 percent of a bank’s total capital. Thus, the use of Tier 2 capital is limited by the Tier 1 capital.

Capital adequacy is the area that triggers the most regulatory action. This is the result of the Federal Deposit Insurance Corporation Improvement Act of 1991, which created a concept known as Prompt Corrective Action (PCA). PCA requires federal banking regulators to take quick action against inadequately capitalized, FDIC-insured depository institutions before the institutions exhaust their capital and, therefore, pose a threat to the federal deposit insurance fund should they fail. The PCA provisions were Congress’ response to the high volume of bank failures in the late 1980s and early 1990s, when more than 1600 banks were either closed or received FDIC financial assistance, causing large losses to the insurance fund. PCA aims to resolve banking problems early and at the least cost to the Bank Insurance Fund.