In the aftermath of the 2008 financial meltdown and subsequent bailouts of banks by the U.S. Treasury, more attention is being focused on whether banks maintain adequate levels of equity capital, which serves as a shock absorber when banks run into difficulties.

Recall that in late 2008/early 2009, the government purchased newly issued preferred stock from many banks (which most have since redeemed) in order to stabilize the financial sector following the collapse of Lehman Brothers. The Treasury hopes to avoid having to come to the bank industry’s rescue in the future by ensuring that banks maintain sufficient equity capital buffers well before financial disasters hit.

Much of the work on formulating bank capital standards has fallen to a group of central bank authorities drawn from around the world known as The Basel Committee on Banking Supervision (BCBS), based in Basel, Switzerland. The group, formed in 1974 to strengthen global bank supervision, has in recent years issued several versions of bank capital and liquidity standards. The latest, referred to as Basel III, is scheduled to be adopted in phases over the 2013-2019 time frame, but final details have not been ironed out yet. Enforcement of the new capital standards is left to each nation, not the Basel Committee.

The Basel III capital standards are complex, and include several capital ratios, as well as liquidity and funding measures. Most of the industry’s attention has focused on a minimum capital-to-asset ratio. Relatively permanent types of capital, like common stock, will comprise the numerator. The assets in the denominator will be adjusted for their riskiness. For example, while government securities would be considered low-risk assets, real estate loans and trading assets would have high risk weightings, which would require banks to hold more capital against these assets. 

In the United States, banks will be required to maintain a minimum common equity capital ratio of 4.5% by 2015. Another buffer, starting at 0.625% in 2015 and increasing to 2.5% three years later, will boost the required capital ratio to 7% in 2019. On top of this, big banks whose hypothetical failure might shake the financial system would have to maintain core capital ratios of up to 9.5% by 2019. Many banks in the United States believe that they already comply with the Basel III standards, but they don’t know for certain, since the details are still being finalized.

As expected, the new capital standards are controversial. Banks argue that the standards will slow loan growth and their ability to expand since they would need to maintain higher levels of capital to back increases in assets. The smaller banks are especially unhappy with proposed risk weightings assigned to mortgage loans, which were considered very low-risk assets prior to the housing downturn but were the source of a lot of the asset-quality deterioration since 2007 and would be viewed as much riskier under Basel III.

Moreover, banks stateside fear that the new capital standards won’t be adopted and implemented consistently worldwide, putting them at a disadvantage to their overseas competitors. It’s conceivable that troubled euro zone nations could be allowed some leeway in implementing the new standards.

Additionally, banks complain that implementing the new capital standards will significantly boost their compliance costs. The required increase in compliance staffing and other expenses would be particularly painful for the small banks. Most big banks already have large compliance departments, but their costs would also rise. The banks also say that they need more time to implement the standards. Indeed, in mid-November, the Federal Reserve Board and other bank regulators said they would need more time to address the small banks’ concerns and would miss the January 1, 2013 implementation date for the new standards.

In all, requiring banks to hold more capital should result in a stronger financial sector, but only if the standards are formulated so as to avoid creating new problems.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.