BAM12030 - Regulatory framework: Regulatory capital

Banks are required to keep sufficient reserves of capital (capital adequacy) to soak up losses so that depositors can always get their money back. This is subject to regulation by the Financial Services Authority (FSA).

Full details can be found in the ‘Interim Prudential sourcebook: Banks’ on the FSA website. But broadly, the FSA has to ensure that banks manage their risks effectively (for more on risks see BAM12055). The FSA checks that a bank’s systems and controls are adequate to track and manage risk. It also ensures that a bank has capital reserves commensurate with that risk. These reserves are there to absorb losses and maintain liquidity.

There are a number of key requirements for the capital of banks.

• A bank’s capital should be capable of absorbing losses. This means in practice that holders of capital are the last creditors to be paid in the event of a liquidation.
• The capital should have no fixed costs so there should be no contractual obligation to pay dividends. Similarly where certain capital is in the form of debt, interest payments must be capable of being deferred.
• The capital should be fully paid up so that the bank has the funds.

Regulatory capital is defined in the UK in terms of Tiers 1, 2 and 3 moving from equity through to various kinds of debt. Banks have to submit form BSD3 to the FSA at least semi-annually. This form shows the regulatory capital divided between its different elements.

Some banks display the details of their capital structure in the investor relations section of their website.

The FSA also monitors large credit exposures. The bigger the exposure, the more likely it is to threaten the solvency of the bank in the event of default. A bank must notify the FSA if it proposes to enter into a transaction or transactions which would lead to an exposure of 25% of the bank’s capital.