Capital Adequacy Standards Capital Adequacy:

Capital Adequacy Standards

Capital adequacy: Scope and coverage; origin and development; and the need for developing more stringent standards

Capital adequacy standards for banks demand that lending institutions have an adequate amount of capital on hand to mitigate risk for investors. Capital adequacy is defined as the percentage ratio of a financial institution's primary capital in relation to its loans and investments. Reserve requirements were initially imposed upon banks during the Great Depression, to prevent catastrophic 'runs' where consumers withdrew large amounts of funds, all at the same time.

Capital adequacy standards are not limited to the United States. For example, the Bank for International Settlements (BIS), an international organization of central banks, imposes standardized reserve requirements on all of its member banks. It demands that all of its banks have a primary capital base equal at least to eight percent of their assets (Capital adequacy, 2009, business dictionary). Until the 2007 credit crisis, the trend of U.S. regulators was to find ways to relax such capital adequacy standards and encourage a freer hand in lending. In 2003, to cite one example, the SCC, Board of Governors of the Federal Reserve System (Board), FDIC, and OTS collectively, permitted sponsoring banks, bank holding companies, and thrifts to exclude from their risk-weighted asset base those assets in asset-backed commercial paper (ABCP) programs (Risk-based capital, 2003).

The ensuing years also saw divergence between U.S. And European standards in other respects: EU and U.S. definitions of defaulting on loans are significantly different. For example, the U.S. considers a debtor to be default if any wholesale exposure has been placed in a non-accrual status consistent with the Call Report or Thrift Financial Report Instructions. The EU considers a default to occur when the bank makes a determination that the borrower is unlikely to pay its obligations (Risk-based capital, 2006). The EU approach is thought to encourage greater scrutiny of borrowers before a loan is made and more diligent supervision of debtors afterwards.

EU nations have blamed deregulation in the U.S. sector for the credit crisis and subsequent recession, specifically the complex risk exposures not fully understood and assessed by banks and investors; poor and fraudulent underwriting standards; lack of investor and agency due diligence; a failure of transparency; and the structure of compensation schemes and incentives in the U.S. banking industry (Griffin 2008). The failure of the U.S. capital adequacy standards was apparent when even U.S. banks that possessed what would, under normal circumstances be adequate capital reserves were taxed in the subsequent panic, after Lehman Brothers was not 'bailed out' by the U.S. government and many lenders demanded a return on their investments.