Why Talk of Bank Capital ‘Floors’ Is Raising the Roof

IMF Blog, June 8, 2017

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Bank capital serves as a buffer to absorb losses; depletion of capital can put deposits and other borrowed funds at risk, leading to bank runs, bank failures, and wider systemic distress.
Calculating appropriate capital levels is contentious between regulators and banks because capital should be commensurate with business risks and systemic risks.
The specific unresolved issue: a proposal to establish a “floor,” or minimum, for the level of capital the largest banks must maintain.

The Basel Committee on Banking Supervision brings together regulators from 28 countries and establishes rules governing appropriate capital levels.
Basel III is the current version of these rules and is a key element of international regulatory reform following the global financial crisis of 2008.
Basel III was adopted in late 2010 for implementation over a seven-year period; it raised the quantity and quality of bank capital and introduced new standards for liquidity risk and limits on leverage.
The largest global banks have been gradually allowed to use their own internal models to calculate capital needed for different types of risk; historical milestones cited:
- Basel Accord of 1988 (Basel I) used only standard risk weights provided by supervisors.
- In 1996, some banks were allowed to develop their own internal models for evaluating market risk.
- Basel II, adopted in 2004, introduced a standardized approach and an internal ratings-based approach, and required a temporary floor equivalent to 80 percent of the level calculated from standard risk weights.

The floor serves as a safety net to internal risk-based approaches:
- Gives banks and supervisors time to intervene if changes are needed before full reliance on internal models.
- Constrains the degree to which internal models can reduce capital below a minimum standard.
- Makes it easier to compare outcomes across banks through disclosure of standardized approach outputs.
The Basel Committee seeks to reintroduce the floor as a more permanent feature of the enhanced Basel III framework, based on a revised standardized approach.

Tests showed banks with similar portfolios produced very different capital requirements when using internal models, raising the possibility of underestimation of risks or gaming the models to reduce required capital.
Addressing risk weight variability became a top priority for the Basel Committee.

Revising the standardized approach to better capture the riskiness of bank assets, making it a better complement to internal models.
Limiting the use of the internal risk-based approach.
Implementing a floor to mitigate internal model risk and to make it easier to compare outcomes across banks.

Some argue the leverage ratio established under Basel III already serves as a backstop, questioning the need for a floor.
If a floor is applied, debate centers on whether it should be set at 80 percent (as in Basel II) or at some other level.
The Basel Committee’s governing body has emphasized enhancements should not lead to a significant, overall increase in capital requirements across banks.

The authors view the risk-weighted capital adequacy ratio, leverage ratio, and output floors as all essential elements of a robust capital framework:
- Capital adequacy ratio: relates risk to capital, but is complex and makes comparisons difficult.
- Leverage ratio: constrains balance sheet growth relative to capital, is not risk sensitive, is simple to calculate, and provides a backstop.
- Floor (output floor): addresses the risk that internal models may not perform as expected, constrains unwarranted capital relief, and facilitates comparison across institutions.
Supervisory capacity to ensure effective oversight of internal models remains a work in progress; banks have incentives to game models and reduce capital holdings.
A referenced recent study by Federal Reserve economists finds manipulation of risk weights to be widespread.
Well-capitalized banks are more likely to lend to the real economy and less likely to engage in excessive risk-taking that could threaten financial stability.
Conclusion: Properly calibrated and carefully phased Basel III enhancements—particularly a floor on risk models—can prevent excessive variability in capital outcomes, allow meaningful comparison across institutions and countries, and still permit risk-sensitive approaches. The capital floor is described as a linchpin of this system.

Author attribution: Tobias Adrian, Aditya Narain — June 8, 2017