Picture this: You’re in your car, driving down the road, and something goes awry.

Your car is out of control, and it comes to an abrupt stop when it hits something; and it hits something hard enough that your airbags deploy.

You’ve never thought much about your airbags before, and most days, it would seem like you didn’t need them at all. But because of your airbags, you are protected from an impact that could’ve otherwise been much worse.

Simply put, that’s what capital requirements — regulatory standards that dictate how much capital a bank must maintain to support its liabilities — can do for banks.

So what are these requirements, anyway, and what even is capital? We’ll break it down for you.

Capital 101

Anyone with a bank account knows banks house money, which for account holders is a deposit and for the bank a debt. Deposits are liabilities, not capital. Capital comes from shareholders, or owners, whose stake in the bank forms the bulk of its capital.

“Bank capital is essentially the difference between a bank’s assets and its liabilities. For a bank to conduct business, its assets must exceed liabilities, and the amount of the excess is bank capital,” said James Yacobucci, head of bank partnerships at private-label fintech Torpago.

Capital requirements are “there to be the first loss bearer of things that happen to a bank, so if a bank’s loans go bad, the first people to take losses aren't depositors,” said Steven Kelly, associate director of research at the Yale Program on Financial Stability.

“You want somebody like a stockholder to be the first person to take that loss. There's a lot less economic risk in someone who holds stocks losing money than there is in depositors losing money, right? I mean, we'd call that a crisis,” Kelly said.

Capital requirements are set by the Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency and are modeled after frameworks made by the Basel Committee on Banking Supervision, composed of regulators from all over the world.

Capital types, and how they’re reflected in capital requirements

In the U.S., there are three types of capital. There is common equity tier 1, made up of common shareholder equity minus intangibles. Next up is tier 1 capital, which is the sum of common equity tier 1 plus some preferred stock, qualified minority interests and certain assets that are deemed by regulators to be stable enough to count as tier 1 capital. The third type is tier 2 capital, which comprises all other capital line items considered safe enough to count as reserves but too risky to count as tier 1 capital.

How much capital a bank must maintain is determined by its size and complexity, including what types of loans and investments it owns.

“Regulators use measures of a bank’s assets as a proxy for risk. If a bank has more assets, regulators perceive the bank as riskier, and thus require that institution to hold more capital. This relationship is expressed through four ratios, where two definitions of assets are the denominator and three definitions of capital are the numerator,” wrote Simon Gilbert, analyst at financial advisory firm Klaros Group, in a blog post.

Which assets are held influences how much capital a bank must have.

“Because risks vary significantly among various types of assets, regulators often require more capital to cushion against loss on risky assets like loans to highly leveraged cyclical companies than on holdings of U.S. Treasury notes,” Yacobucci said. “Accordingly, regulators apply higher risk weights in the denominator for riskier assets. For example, for FDIC-supervised banks, investments in U.S. government bonds carry a risk weight of 0%, while second or third lien residential mortgages carry a risk weight of 100%. Unsecured loans with no guarantee that are 90 days past due are assigned a risk weight of 150%,” he said.

The four ratios used to determine a bank’s capital requirements, and their minimum- and well-capitalized standards, are as follows:

• Tier 1 Leverage Ratio: This ratio measures tier 1 capital divided by average tangible assets — loans, securities or other assets — for a given financial quarter. Minimum: 4%, well-capitalized: 5%.
• Common Equity Tier 1 Risk-Based Capital: This ratio measures tier 1 common equity divided by risk-weighted assets, which are assets with an adjusted value meant to reflect their credit risk (Treasury bonds have a 0% weighting; consumer loans, 100%). Minimum: 4.5%, well-capitalized: 6.5%.
• Tier 1 Risk-Based Capital: This ratio is tier 1 capital divided by risk-weighted assets. Minimum: 6%, well-capitalized: 8%.
• Total Risk-Based Capital: This ratio is total capital — tier 1 and tier 2 capital — divided by risk-weighted assets. Minimum: 8%, well-capitalized: 10%.

Regulatory scrutiny is common when a bank falls below well-capitalized. For this reason, banks typically look at well-capitalized requirements as a minimum, and aim to operate with capital materially above what’s required of them by regulators.

To satisfy their capital requirements, banks manage their capital levels and asset mix. If constrained by a risk-based capital ratio, a bank may shift its asset mix toward less risky.

“Banks can increase capital by retaining earnings, raising equity from investors and selling assets at a gain, all of which increase a bank’s assets without raising its liabilities,” Gilbert said.

If a bank is undercapitalized, it may ask its bank holding company — if it has one — to inject funds into the bank. Regulators may also require the bank to seek to raise capital from investors. Alternatively, regulators may require the bank to define and follow a capital plan designed to improve its capital ratios and involving action steps like asset sales and capital raising, Gilbert said.

So what is Basel, anyway?

To ensure a fair and level playing field for banks internationally, U.S. regulators lean heavily on recommendations from the Basel Committee on Banking Supervision, mentioned above. The BCBS is the global standard setter banking regulation, made up of central banks and bank supervisors from 28 jurisdictions worldwide.

The committee first met in 1975 — with representatives from the central banks of 10 nations including the U.S. —after the failure of Germany’s Bankhaus Herstatt.

Following its first standards-setting publication, Basel Concordat, BCBS has published large-scale updates known commonly as Basel I, Basel II and, most recently, in response to the 2007-08 financial crisis, Basel III.

Tenets of Basel III were unveiled in 2010 and include stricter requirements for the amount and quality of regulatory capital — in particular, reinforcing the central role of common equity; along with a minimum liquidity ratio and a leverage ratio, which is a minimum amount of loss-absorbing capital relative to all of a bank’s assets and exposures.

“[Implementation is] taking a long time because feelings run strong for and against, and implementation has been delayed several times,” said Michele Alt, co-founder and partner at Klaros Group, who added that it’s scheduled for full implementation by 2028. More on that later.

While Basel has “no force of law in the U.S.,” Kelly said, the committee’s output comprises “the rules of the road to conduct banking globally.”

“If [U.S. banking regulation] doesn’t resemble the international rules, these other countries aren’t going to allow our banks to do business there, and they’re not going to do business with our banks, because we seem less safe,” Kelly said.

Tangible implications of capital requirements

Jordan Sternlieb, senior partner in financial services at management consultancy West Monroe Partners, noted how large an impact capital requirements have on almost every area of a bank, including in its risk strategy.

“Capital requirements can impact a bank’s ability to grow inorganically as M&A regulatory approval is dependent on the pro-forma capital structure and capital ratios of the combined bank,” Sternlieb said.

Even with capital requirements in place, following them doesn’t guarantee that banks remain solvent. It just makes it a lot harder for them to fail. Current capital requirements don’t account for changes in the market value of loans or bonds, Gilbert said. Therefore, it’s possible that banks, without accounting for unrealized losses, might seem more solvent than they really are.

“For instance, as interest rates dramatically increased over the past two years, many banks accumulated unrealized losses stemming from their securities portfolios. [Silicon Valley Bank] — which remained well-capitalized according to the four regulatory capital ratios up to the day it failed — was one of those banks,” he said. “Thus, while capital standards may be indicative of a bank’s health, they are far from comprehensive.”

What about big banks?

The 2007-08 financial crisis put a spotlight on “too-big-to-fail” banks — the idea that some banks are so large and so influential that their failure could trigger widespread financial instability.

The Fed applies stricter safety and soundness requirements to these large entities than it does to smaller banks, with globally systemically important banks under the most scrutiny.

The most common test applied to these institutions are stress tests, in which the Fed devises challenging economic scenarios and applies them to banks based on their up-to-date data. These tests evaluate the financial resilience of institutions — estimating losses, revenues, expenses and resulting capital levels under hypothetical economic conditions.

The results of the stress tests determine a stress capital buffer requirement, which is 2.5% at minimum, Gilbert noted. Regulators then add this buffer to the minimum CET1 ratio, which is 4.5%. An additional surcharge ranging from 1.5% to 3.5% applies to G-SIBs.

The largest banks may be subject to CET1 capital requirements ranging from 7% to north of 13%, he said. The largest requirement for a bank this year — Credit Suisse, before UBS acquired it — was 13.5%.

Hot topic: Basel III endgame

Basel III has taken a long time to come to fruition. Now in its final phase of implementation, the last set of rules has been dubbed “Basel III endgame.”

If approved, Basel III endgame would require banks with $100 billion in assets to boost their capital buffers by an estimated 16%. The U.S.’s eight G-SIBs would face a roughly 19% increase.

Banks with less than $100 billion in assets would be exempt from the rule.

U.S. regulators unveiled Basel III endgame requirements after several high-profile bank failures in March and May. But banks and bank lobbyists have been vocally opposed to the stiffening capital requirements, with JPMorgan CEO Jamie Dimon calling the proposed regulations “hugely disappointing” and Goldman Sachs taking out an ad campaign, imploring the Fed to “stop the squeeze.”

Opponents say Basel III endgame could make lending more restrictive, resulting in cash challenges on Main Street.

Lobbyists, too, are stepping up their game. Center Forward, a nonprofit led by former Rep. Robert “Bud” Cramer, D-AL, took out an ad on Sunday Night Football last month, claiming the Fed was looking to implement “unnecessary capital rules that will raise costs for everything we buy.”

It stands to reason that banks wouldn’t be enthusiastic about more rules.

“Capital requirements can be quite burdensome for bank earnings and are therefore a crucial consideration for bank management and boards. If there were no capital rules, banks would maximize their leverage by borrowing as many insured deposits as possible and putting those funds into higher-risk, higher-reward assets,” Gilbert said. “This is a classic case of moral hazard: If the bank fails, the Deposit Insurance Fund pays for it; if it doesn’t, the bank will have made a return with relatively little investment. In other words, banks would prefer to run with as little capital as possible.

“So banks — especially community banks that will be facing trickier capital positions in the next few years due to securities portfolios riddled with unrealized losses — do not want to deal with increased capital requirements,” Gilbert said.