The Nature of Capital Adequacy Constraints Under the Basel Accord

Abstract

The 1988 Basel Accord defined what constituted bank capital, and put in place minimum capital adequacy ratios for each type of capital as well as for total bank capital. Regulators as well as market participants, however, have come to rely on Tier 1 capital or equity capital as the main constraint for controlling bank behavior. In this paper, we show that despite the various constraints placed on the bank’s optimization program by the Basel Accord, only one constraint binds. That is, only the minimum total capital ratio--which includes equity and debt--of no less than eight percent, is the constraint that matters for analyzing bank behavior. Thus, the overemphasis on equity capital by regulators and market participants is likely to raise the cost of lending for banks, which would affect bank profitability, credit extension, and the overall economic activity.