Capital Requirements for Banks and Insurance Companies
A sufficiently high capital base is seen as crucial for the stability of a bank or an insurance company. The capital base plays a decisive role in supervision, and it is also essential for an institution’s reputation. As a consequence of the financial crisis, markets now increasingly focus on capital endowment.
Capital requirements are harmonised on the EU level. Measures to improve the quality and quantity of capital are currently under discussion.
In order to stabilise the banking system and to prevent unfair competition, the amount and the quality of equity capital required by banks have been harmonised at the international level. Basel II is the second of the Basel Accords issued by the Basel Committee on Banking Supervision. The accord comprises recommendations for banking laws and regulations. The objective was to create an international standard that would allow banking regulators to identify the amount of capital banks need to safeguard against different types of financial and operational risks.
Basel II is based on a three pillars concept:
- minimum capital requirements:
The first pillar deals with the maintenance of regulatory capital, calculated for three major risk components bank faces: credit risk , operational risk and market risk including foreign exchange risk.
- supervisory review:
The second pillar deals with the regulatory response to the first pillar. It gives regulators improved tools and provides them with a framework for dealing with all the other risks a bank may face.
- market discipline:
The third pillar deals with the strengthening of market discipline. Market discipline should work as a supplement to regulation, since the sharing of information facilitates the assessment of a bank by investors, analysts, customers, other banks and rating agencies. This in turn leads to good corporate governance.
Basel III is a global framework for the regulation of the banking sector and was agreed upon by the members of the Basel Committee on Banking Supervision in 2010. It aims to enhance the stability of financial markets, protect investors and strengthen the ability of financial institutions to withstand crises. Therefore, Basel III establishes new requirements primarily concerning capital adequacy, liquidity and leverage ratio.
The new capital standards will require banks to raise the quality as well as the quantity of regulatory capital compared to the current Basel II rules. This will contribute to better loss absorption and thus, higher resistance in times of banking crises. Systemically important financial institutions will have to meet even higher capital requirements. Different types of capital buffers will be introduced as a supplementary safeguard.
Basel III further introduces two new liquidity ratios. First, the so called „Liquidity Coverage Ratio“ will require banks to hold enough liquid assets to withstand a short-term stress scenario, while the second ratio („Net Stable Funding Ratio“) constitutes a long-term structural ratio.
The new leverage ratio will establish a non-risk based measure in order to limit excessive leverage and contain the cyclicality of lending. Basel III will also require banks to assess the credit risk of counterparties and respectively adjust their risk management.
In conclusion, the rules of Basel III will strengthen the regulation, supervision and risk management of financial institutions.
The European Union will implement the Basel III standards in a legislative package which consists of a regulation („Capital Requirements Regulation/CRR I“) and a directive („Capital Requirements Directive/CRD IV“). However, the implementation will go beyond the Basel III framework and regulate further aspects such as enhanced rules for corporate governance and a harmonized sanctioning regime within the Single Market.
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The risk-oriented and prospective approach of Solvency II leads to a complete realignment of solvency calculations, and to modifications of supervisory measures and instruments. Similar to the banking sector model “Basel II", the new provisions are divided into three pillars:
- Pillar 1: quantitative requirements
- Pillar 2: qualitative requirements and supervisory rules
- Pillar 3: supervisory reporting and disclosure
The new supervisory rules take qualitative standards to a greater extend into account, and they pursue a business approach. For instance, professional risk management will be a crucial factor within the new governance system.
Solvency II goes beyond Basel II in that it also comprises accounting rules for the valuation of assets and liabilities (economic total balance sheet approach) that aim to be consistent with the International Financial Reporting Standards.