Learning Objectives:

  • Understand the purpose of bank capital.

  • Apply the Basel capital adequacy framework.

  • Explain the Internal Capital Adequacy Assessment Process (ICAAP).

  • Distinguish between regulatory capital, economic capital, and RAROC.

7.1 The Purpose of Bank Capital

Bank capital serves as a buffer to absorb losses and protect depositors. The University of Dundee module covers “bank regulatory capital and requirements” as a core topic, elaborating on “capital frameworks and requirements” . The University of Reading module covers “bank capital, risk and the difference between economic and regulatory capital, the latest bank capital regulation, credit rating systems, and stress testing, and the overall global context” .

Functions of Bank Capital:

  • Absorbing unexpected losses.

  • Protecting depositors and creditors.

  • Maintaining public confidence in the banking system.

  • Supporting ongoing operations during periods of stress.

7.2 Regulatory Capital – The Basel Framework

The Basel framework provides a global standard for capital adequacy . The University of Reading module covers “the latest bank capital regulation” . The University of Bologna module covers the “Evolution of Risk Management Regulation in banking” .

Tier 1 Capital: Core capital, including Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) instruments.
Tier 2 Capital: Supplementary capital, including subordinated debt.
Capital Buffers: Capital conservation buffer, countercyclical buffer, and G-SIB/D-SIB buffers.

Minimum Capital Requirements:

  • CET1 Ratio: Minimum 4.5% of Risk-Weighted Assets (RWA).

  • Tier 1 Ratio: Minimum 6% of RWA.

  • Total Capital Ratio: Minimum 8% of RWA.

  • Leverage Ratio: Minimum 3%.

Risk-Weighted Assets (RWA): Assets are weighted according to their risk. The calculation of risk-weighted assets is independent of any discounts . The RWA for operational risk is equal to 12.5 times the operational risk capital requirements .

7.3 The Internal Capital Adequacy Assessment Process (ICAAP)

ICAAP is the bank’s own assessment of its capital needs under normal and stress conditions. The BTRM programme covers “ICAAP principles” and “strategic risk and ICAAP.”

Components of ICAAP:

  • Risk Identification: Identifying all material risks (credit concentration, interest rate risk in the banking book, liquidity risk, strategic and reputational risks).

  • Capital Projection: Forecasting capital needs under various scenarios.

  • Stress Testing: Assessing capital adequacy under stress.

  • Capital Planning: Strategies for maintaining adequate capital.

7.4 Economic Capital and RAROC

Economic Capital: The capital required to cover unexpected losses at a given confidence level. It is used for internal risk management and performance measurement.

RAROC (Risk-Adjusted Return on Capital): Calculated as (Revenue – Costs – Expected Loss) / Economic Capital. RAROC is used for:

  • Performance measurement.

  • Pricing.

  • Capital allocation.

  • Business unit evaluation.

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