With the comment period for the U.S. regulators’ proposed rules to implement the Basel III capital accords recently closed, bank capital issues are receiving renewed attention in policy discussions and in the media. Because bank capital is a crucial component of bank regulation that impacts both safety and soundness and economic growth, The Clearing House Banking Brief will examine the topic in the coming weeks, beginning with a high-level discussion of regulatory capital before moving on to the cost of capital, the Basel Committee process, and the details of the U.S. regulators’ proposed rules.

Bank supervisors in every country specify the type of assets and liabilities that can be used to calculate capital for purposes of safety and soundness, known as “regulatory capital.” Regulatory capital is often expressed as a ratio of capital to risk-weighted assets (RWA) held by a bank; capital is the numerator and RWA are the denominator. These ratios evaluate the amount of a bank’s qualifying capital in relation to the amount of assets on a risk-adjusted basis. Risk weights are assigned by supervisors based on their perception of the riskiness of a particular asset class. Ultimately, banks must hold capital in direct relation to the assigned risk weights.

In the event of stress, regulatory capital serves as a buffer that allows banks to absorb losses without endangering depositors1 and other creditors as well as equity investors. However, not all capital is treated equally and regulators set eligibility criteria for regulatory capital instruments. The recent financial crisis demonstrated that some non-common stock capital instruments did not absorb losses to the extent expected, so market participants and regulators alike are placing an increased focus on common equity. Common equity is generally considered the most robust form of regulatory capital because equity investors do not need to be repaid in the event of insolvency.

Shareholders’ equity is the net worth of a bank and represents the stockholders’ claims to a business’s net assets after all creditors and debts have been paid. It can be calculated by taking the total assets and subtracting the total liabilities. Shareholders’ equity is derived from either cash paid in by investors when the company sold stock (preferred stock, common stock, additional paid-in-capital) or via retained earnings, which are the accumulated profits a bank has held on to and not paid out to its shareholders as dividends.