Capital Adequacy

Capital adequacy requirements involve a definition of which instruments constitute regulatory capital (including appropriate deductions from capital), and the specification of the amount of capital institutions should hold. The amount of capital to be held may be based on several factors, the most common being various proxies for risk (e.g. risk weights for assets based on their perceived degree of credit risk, net positions in foreign exchange, and net positions in traded securities subject to market risk), and estimates of liabilities (e.g. actuarial estimates of insurance liabilities, and historic net claims payments), but also on other factors, such as the level of the fixed operating expenses of an institution.

The adoption in 1988 by the Basle Committee on Banking Supervision of an international accord for bank capital adequacy (the so-called "risk-based capital" accord) was a significant step in more closely relating capital requirements for banks to their riskiness. This accord is mirrored in the 1989 EEC Directives regarding the "own funds" (i.e. regulatory capital) and "solvency" of banks. In 1993 the EEC adopted capital adequacy rules applicable to the securities trading and foreign exchange operations of investment firms and banks, which also makes applicable to investment firms certain of the own funds and solvency requirements applicable to banks, and thus creates an integrated capital adequacy requirement applicable to banks and investment firms. The EEC had previously adopted directives establishing capital requirements for life and non-life insurance companies, but as yet they are not integrated with the requirements applicable to banks and investment firms. 33/ Despite the present exclusion of insurance companies, it should be presumed that some form of group-wide application of capital adequacy requirements eventually will become an internationally accepted facet of financial conglomerate regulation and supervision.

One means to apply capital adequacy standards to financial conglomerates is to utilize the principle of consolidated regulation: a uniform capita/ adequacy requirement would be applied to all financial institutions within a conglomerate based on their consolidated accounts and risk positions. This consolidated approach would incorporate a common standard for the amount of capital required to be held against all types of risks run by different types of financial institutions, and a common definition of regulatory capital. Regulatory capital would be determined after application of full accounting consolidation techniques for all group financial entities. 34/ Such accounting techniques will serve to eliminate the effects of intra-group transactions, and will make more transparent the net capital position of the group. 35/

For the authorities, consolidated application of a uniform capital adequacy requirement in this manner would require that they harmonize the standards they presently utilize for defining the amount of capital to be held for different financial risks (e.g. credit risk, foreign exchange rate risk, position risk, and estimates of insurance underwriting liabilities) without regard to the type of institution conducting the activity. This effort will need to address the acceptable manner for netting offsetting risk positions in different group financial entities. The authorities would need to agree on a common definition of regulatory capital, as well as appropriate deductions from capital. Such agreement among the authorities might retain elements of the capital requirements traditionally employed by the different supervisors. For example, it could be agreed that certain forms of regulatory capital would be permitted to support only certain types of risks (e.g. shorter-term capital to support securities underwriting positions).

Complete harmonization of all standards may not be required. So long as any remaining differences are transparent to financial institutions, the users of published financial statements, and the supervisors themselves, certain differences in the capital standards and/or the definition of regulatory capital could be tolerated. This tolerance could extend to the accounting principles that would otherwise need to be made consistent among all types of financial institutions in order to achieve a common definition of regulatory capital (e.g. loss provisioning, income and expense recognition, asset and liability valuation, gain and loss recognition and deferral, and intangible asset inclusion and amortization).

Consolidated application of a uniform capital adequacy requirement would have the advantages of creating a level playing field for minimum capital charges between different types of financial institutions engaged in the same or similar businesses, and between financial conglomerates conformed in different structures. It would promote transparency by presenting a single financial statement for the entire financial group that eliminates the consequences of intra-group transactions, and by presenting individual financial statements for each entity prepared under the same standards. Utilizing one set of standards applicable to all financial institutions also would facilitate market comparisons of different types of financial institutions.

If consolidated application of a uniform capital adequacy requirement is not considered feasible or desirable, alternative methods must be adopted. The existing capital adequacy rules applicable to the various types of financial institutions will need to be modified for application in the financial conglomerate context. A likely feature of this alternative will be the absence of full accounting consolidation of all group financial entities. For this reason, the modifications to existing rules should have the objectives of avoiding the double counting of capital among regulated group entities, and the overstatement of capital within any regulated group entity, both of which can be consequences of transactions with other group financial institutions. 36/

A commonly utilized technique to avoid the double counting and overstatement of capital among regulated institutions is to deduct from an institution's regulatory capital certain of its investments and other credit exposures to other regulated group member institutions. In practice, there are at least three alternative means of defining the relevant investments or credit exposures. The first is to require the deduction of any investment that corresponds to the capital that the other group member entity is required to hold under its own capital requirement. 37/ This method, in effect, presumes that the capital in the other member entity in excess of its minimum regulatory requirement is available to meet the capital requirement of the subject regulated entity. The second method is more conservative. It requires the deduction of any investment that corresponds to the regulatory capital of the other member entity (i.e. the capital the other member entity is required to hold plus any additional regulatory capital actually held by that entity). This method presumes that the other member's capital is required to support the risks it runs, regardless of the amount of capital required under its regulatory requirement.38/ The third method is more conservative still. It requires the deduction of all forms of financing provided by the subject regulated entity to the other member entity, including investments. This method precludes the double counting of capital that might arise in transactions where capital is created in the regulated entity by creating a receivable due from the other entity. 39/ Further, this method provides a higher level of comfort regarding the subject entity's insusceptibility to contagion from the other group member entity, in that the former can withstand the loss of its entire credit exposure to the latter and still meet its minimum capital adequacy requirement.

To fully preclude the overstatement of capital that might arise due to transactions between a regulated institution and unregulated group entities, the third deduction method noted above would need to be employed. If such a provision is viewed as excessively restrictive by the authorities, they must weigh the implications of existing and potential intra-group transactions in their markets in terms of the transparency of groups' and individual institutions' financial position, and should consider adopting prudential regulations applicable to such transactions, particularly to those whose effects will not be eliminated under the chosen capital adequacy methodology. 40/

These alternative methods for the group-wide application of capital adequacy requirements may prove simpler to adopt than a uniform capital adequacy requirement, in that harmonization of requirements among different types of institutions would not be required. However, the alternative approaches lack most of the advantages of the fully consolidated approach. They will likely preserve disparities in the minimum capital adequacy requirements applicable to different types of financial institutions, and may produce inconsistent results when applied to groups conformed in different structures. They do not, in themselves, achieve relevant supervisory objectives regarding contagion and transparency. 41/ Finally, their use can contribute to the potential for regulatory arbitrage, where certain activities are shifted to the regulated entity subject to the least stringent capital requirements for that particular activity, or to non-regulated entities. 42/

Regardless of whether the authorities adopt a uniform capital adequacy requirement or the alternative methods, it is critical that supervisors recognize that adherence to a capital rule does not mean that a given institution or group of institutions is adequately capitalized. Capital adequacy requirements incorporate only crude measures of the riskiness of financial institutions, and there are practical limitations to increasing their accuracy (e.g.. the need to avoid excessive complexity). Adequate supervision therefore requires that minimum capital adequacy requirements be coupled with subjective assessments of riskiness and management practices in the regulated entities and, to the extent possible, in the unregulated entities which are part of the group. For regulated entities, such assessments should lead to a situation where most institutions are required to hold capital in amounts greater than the minimum requirement. With respect to unregulated entities, such assessments may lead to a requirement that related regulated entities reduce their exposures to the unregulated entity, or take other actions designed to minimize the potential for contagion and to promote the transparency of its relationship with the unregulated entity. In the conglomerate context, qualitative assessments of this nature need be made on a group-wide basis by at least one of the agencies responsible for the supervision of the component financial institutions.

Large Exposures and Connected Lending Limits

In general, quantitative risk limits serve to constrain the riskiness of financial institutions and reduce the potential for a sudden shock (e.g. counterparty default) to render them insolvent. As such, risk limits can reduce potential contagion arising from institutions subject to such limits. Common examples include large credit exposure limits, connected lending limits and foreign exchange position limits. 43/

With respect to certain risks, minimum capital adequacy requirements can serve a purpose similar to risk limits: to the extent that capital rules accurately capture the underlying risk, the need for institutions to comply with the capital charges can function to constrain the level of risk they assume. In the capital adequacy requirements adopted by the EEC and proposed by the Basle Committee on Banking Supervision, for example, risks arising from positions in foreign currencies and traded securities are addressed in this manner. 44/

For other risks, capital rules alone may not serve to sufficiently constrain risk. The most notable example is credit risk. The Basle and EEC capital adequacy requirements' treatment of credit risk is geared to a diversified portfolio of exposures, and is not intended to function as a constraint on credit exposures to individual counterparties. For this reason, an explicit limit on large exposures to a individual counterparty or related group of counterparties is a key element of the EEC's consolidated supervision framework. 45/ As such, it is likely that some form of group-wide application of a large exposures limit will become an accepted facet of financial conglomerate regulation and supervision.

Large exposures limits can be applied on a uniform and fully consolidated basis across the financial group in a manner similar to uniform capital adequacy requirements. This would require the establishment of a common definition for what constitutes an exposure 46/, what constitutes an economically-related group of counterparties 47/, the base against which the limit will be established (e.g. regulatory capital), and the limit itself. 48/ The regulatory capital of the group would be computed based on full accounting consolidation techniques. The limit would be applied to the consolidated group and to each financial entity separately. 49/

If consolidated application is not considered feasible or desirable, large exposures limits should be applied separately to individual group financial entities. To take account of the potential that capital is double counted among the individual entities, or is overstated in an entity due to transactions with other group entities, the authorities should consider using the deduction method noted above in the discussion of capital adequacy requirements to scale-back the capital base against which the limit would be applied in each entity. At the group level, this will produce a result similar to the consolidated application of the large exposures limit. At the level of the individual institution, however, utilizing this approach is less compelling than in the case of the capital adequacy requirements, and will produce anomalies among institutions.50/

The authorities will need to make a policy decision as to whether the large exposures limit applicable to connected parties (i.e. non-financial group members and other related parties) should be lower than for unrelated parties. The supervisory concern in this regard is autonomy, and the potential that directors and managers may act in a less than objective manner in making decisions on potential exposures to related parties. Adopting a separate connected party exposure limit will require definition of what constitutes a connected party, which reasonably could be more conservative than the definition of an economically-related group of counterparties. 51/

The authorities will also need to make a policy decision as to whether further regulation of Intra-group exposures IJ appropriate. Given supervisory concerns regarding potential contagion. the authorities may wish to establish constraints on the ability of individual regulated institutions to take on significant exposures to certain other group member entities (e.g. exposures to unregulated entities for which an adequate assessment of risk cannot be made). In such critical Instances, the exposures might be made subject to prohibitions. limits, or requirements for prior supervisory approval. Where less supervisory concern exists, such transactions might be subject to a requirement for ratification by the board of directors or a committee of the board of directors comprised of non-executive directors. Additionally, all intra-group transactions could be subjected to requirements that they be concluded on an armslength basis.