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

_IMF Blog, June 8, 2017_

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## Bibliographic details
- Authors: Tobias Adrian, Aditya Narain
- Published: June 8, 2017

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### Importance of bank capital and the dispute over floors
- 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.

### Basel Committee role and Basel III context
- 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.

### Purpose and mechanics of the floor
- 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.

### Problem motivating the floor: variability and potential gaming
- 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.

### Options considered by 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.

### Debate: floor versus leverage ratio
- 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.

### Authors’ assessment and policy stance
- 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*

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## References

- [https://www.imf.org/wp-content/uploads/2017/06/BLOG-1099x500-SWITZERLAND-Basel-Man-Walking-in-front-of-BIS-Headquarters_Christian-Hartmann_Newscom.rtrlfour181184.jpg](https://www.imf.org/wp-content/uploads/2017/06/BLOG-1099x500-SWITZERLAND-Basel-Man-Walking-in-front-of-BIS-Headquarters_Christian-Hartmann_Newscom.rtrlfour181184.jpg)
- [Bank capital](https://blogs.imf.org/2016/03/03/a-new-look-at-the-benefits-and-costs-of-bank-capital/)

_Source: https://www.imf.org/en/blogs/articles/2017/06/08/why-talk-of-bank-capital-floors-is-raising-the-roof_