How Well Capitalized Are Well-Capitalized Banks?

How Well Capitalized Are Well-Capitalized Banks? T he wave of bank and savings and loan failures in the 1980s and early 1990s, and the resulting losses to deposit insurance funds, served to highlight the need for banks to hold sufficient capital to survive difficult times. In addition, many argued that deposit insurance made it imperative that banks be better capitalized, since deposit insurance reduces the market discipline that depositors might otherwise provide. With reduced market discipline, banks have an incentive to take on greater risks and more leverage than they would if the market fully reflected the increased risk such actions pose. 1 Consequently, recent bank regulatory initiatives increasingly have emphasized the role of bank capital as a cushion to allow banks to absorb adverse shocks without experiencing insolvency. Recent bank legislation and regulation have sought to implement a carrot-and-stick approach that penalizes banks that have too little capital, while reducing the regulation imposed on banks deemed to be well capitalized. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) has served as the cornerstone of a major overhaul of banking legislation unprecedented since the Great Depression. The early intervention component of FDICIA provides for prompt corrective action (PCA) based on capital ratio thresholds, with supervisory intervention in undercapitalized banks that becomes increasingly severe as the bank's capital position deteriorates. 2 Undercapitalized banks are restricted in their activities, and severely undercapitalized banks are subject to early closure. 3 On the other hand, as long as a bank is deemed to be well capitalized, regulators are not required to take any action. This emphasis on bank capital also is found in newly proposed legislation to relax Glass-Steagall restrictions, which would allow expanded activities only at banks that are well capitalized. Nor is the United States the only country to focus on bank capital regulation. With the 1988 adoption of the Basle Accord, an international agreement that set common standards by which to evaluate capital adequacy, many other