The rise of risk-based regulatory capital: liquidity and solvency standards for financial intermediaries

Abstract

This essay traces the risk of risk-based capital standards for regulated financial intermediaries. In a capitalist economy, a private firm seeking finance must negotiate with prospective investors in the open market, which establishes standards about the terms on which debt and equity investment will be forthcoming. In addition to these market financing standards, the capital structure of some financial firms – particularly broker-dealers, federally insured depository institutions, and insurance companies- must also satisfy other requirements imposed by federal or state regulators to promote liquidity and solvency. Regulators take a heightened interest in these firms because they serve a public function in providing credit and other financial services. Part I explains regulatory capital as a corporate finance issue about how capital structure can protect creditors – especially unsecured ones - from unexpected financial losses. The rest of the chapter examines the major features of the regulatory capital regimes that apply to financial intermediaries. Part II starts with depository institutions, i.e., banks. These standards have become the locus of policy debates about risk-based capital. Part III discusses the regulatory capital rules that apply to broker-dealers registered with the U.S. Securities and Exchange Commission. Broker-dealers had long been subject to net capital rules that promote the firm's liquidity so as to promote orderly self-liquidation. More recently, large broker-dealers have been allowed to adopt a risk-based method – akin to that used in bank capital – for meeting their net capital requirements. Part IV considers insurance companies, which adhere to risk-based capital standards imposed by state law. Part V warns that large, complex financial organizations may find themselves inadvertently subject to bank-style capital rules if deemed 'systemically important' by the newly created Financial Stability Oversight Council (FSOC).