Capital Adequacy, Regulation, and Basel Framework
The regulatory landscape for financial institutions: Basel I/II/III, capital requirements, and the interplay between risk management and regulation.
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Capital Adequacy, Regulation, and the Basel Framework
Why Capital Matters
Capital is the buffer between a bank's assets losing value and the bank becoming insolvent. Without sufficient capital, loan losses, market movements, or operational failures can directly impair depositors and trigger systemic crises.
The fundamental equation:
Assets = Liabilities + Equity
When assets decline in value, equity absorbs the loss. If losses exceed equity, the bank is insolvent. Regulators therefore require banks to hold a minimum amount of capital relative to their risk exposures.
Basel I (1988)
The first international capital standard, developed by the Basel Committee on Banking Supervision (BCBS).
Key features:
- Introduced the 8% minimum capital ratio: Capital ≥ 8% × Risk-Weighted Assets (RWA)
- Simple risk-weighting: sovereign bonds (0%), bank exposure (20%), residential mortgages (50%), corporate loans (100%)
- Only credit risk was addressed
Limitations:
- Crude risk weights — all corporate loans treated the same regardless of creditworthiness
- No recognition of portfolio diversification
- Created incentive for regulatory arbitrage (move high-qualit
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