Understanding corporate finance: the legal and regulatory framework: regulatory capital
Banks and building societies are required to keep sufficient reserves of capital (capital adequacy) to soak up losses so that depositors can always get their money back. The Financial Services Authority (FSA) sets out the standards it expects banks and building societies to adhere to in the ‘General Prudential Sourcebook’ which is part of the FSA Handbook. Broadly, the FSA has to ensure that banks’ and building societies’ systems and controls are adequate to manage their risks effectively, and that they have capital reserves commensurate with that risk.
There are a number of key requirements for the capital of banks and building societies.
- Capital should be capable of absorbing losses. This means in practice that holders of capital are the last creditors to be paid in the event of a liquidation.
- The capital should have no fixed costs so there should be no contractual obligation to pay dividends.
- The capital should be fully paid up so that the bank has the funds.
Regulatory capital is defined in the UK in terms of Tiers 1, 2 and 3 (CFM14120) moving from equity through to various kinds of debt. Banks and building societies must report on their regulatory capital to the FSA. The FSA also monitors large credit exposures. The bigger the exposure, the more likely it is to threaten the solvency of the bank in the event of default.