Federal Deposit 1 nsuranceCorporation
Acting Chairman
Andrew C. Hove, Jr.
Division of Research
and Statistics,
Director
Wm. Roger Watson
Editor
Cieorge E- French
Editorial Committee
Frederick S. Cams
Gary S. Fissel
Arthur J. Murion
Administrative
Manager
Detta Voeaar
Editorial Secretary
Cathy Wright
Design and Production
Design and Printing
Unit
The views expressed are those
of the authors and do not neces
sarily reflect official positions of
the Federal Deposit Insurance
Corporation. Articles may be
reprinted or abstracted if the
FDIC Ranting Review and
ajthor(s) arc ctedited. Please
provide the FDlC's Division of
Research and Statistics with a
copy of any publications con
taining reprinted material.
.Single-copy subscriptions arc
available to ihe public free of
charge. Requests For subscrip
tions, back issues or address
changes should be mailed to:
FDIC Banking Review* Office oF
Corporate Communications,
Federal Deposit Insurance Cor
poration, 550 17th Street, N.W.,
Washington, D.C. 20429.
FDIC
Bankin;
Review
Spring/Summer 1993
Vol. 6, No. 1
Table of Contents
Risk-Based Capital Standards for Commercial Banks:
Improved Capital-Adequacy Standards?
byJohnP.O'Keefe Page 1
At year-end 1990, risk-based capital standards were implemented for U.S. commercial banks. The
new standards substantially changed U.S. regulatory standards for assessing bank capital adequacy,
by replacing simple flat-rate standards with standards that explicitly incorporated risk. This study
investigates whether the risk-based capital standards are improved measures of capital adequacy.
The relative merits of both the risk-based and former flat-rate capital standards are discussed. In
addition, brief histories of banks' regulatory capital ratios are used to compare the effectiveness
of the standards. The study concludes that the risk-based capital standards are an improvement
over the flat-rate capital standards they replaced.
The Bank and Thrift Crises — A Retrospective
by David S. Holland Page 16
The years since 1980 have been a tumultuous period for the U.S. banking and thrift industries
and their regulators. Recent improvements in profitability and declines in the number of bank
and thrift failures, however, give reason to beiieve that the worst may be over. The author uses
this respite to review what has transpired and to look ahead.
Commercial Real-Estate Problems: A Note on Changes in Collateral Values
Backing Real-Estate Loans Being Managed by the Federal Deposit Insurance
Corporation
by James L. Freundand Steven A. Seelig Page 26
The most recent economic dislocation to affect the banking industry is the major downturn of
commercial real-estate markets in many areas of the country. In this article the authors report the
results of a survey estimating the decline in collateral values for individual real-estate assets under
FDIC management.
Recent Developments Affecting Depository Institutions
by Benjamin B. Christopher Page31
This regular feature of the FD/C Banting Review con tains informarion on regulatory agency actions,
state legislation and regulation, and articles and studies pertinent to banking and deposit insurance
issues.
Acting Chairman
Andrew C. Hove, Jr.
Division of Research
and Statistics,
Director
Wm. Roger Watson
Editor
Cieorge E- French
Editorial Committee
Frederick S. Cams
Gary S. Fissel
Arthur J. Murion
Administrative
Manager
Detta Voeaar
Editorial Secretary
Cathy Wright
Design and Production
Design and Printing
Unit
The views expressed are those
of the authors and do not neces
sarily reflect official positions of
the Federal Deposit Insurance
Corporation. Articles may be
reprinted or abstracted if the
FDIC Ranting Review and
ajthor(s) arc ctedited. Please
provide the FDlC's Division of
Research and Statistics with a
copy of any publications con
taining reprinted material.
.Single-copy subscriptions arc
available to ihe public free of
charge. Requests For subscrip
tions, back issues or address
changes should be mailed to:
FDIC Banking Review* Office oF
Corporate Communications,
Federal Deposit Insurance Cor
poration, 550 17th Street, N.W.,
Washington, D.C. 20429.
FDIC
Bankin;
Review
Spring/Summer 1993
Vol. 6, No. 1
Table of Contents
Risk-Based Capital Standards for Commercial Banks:
Improved Capital-Adequacy Standards?
byJohnP.O'Keefe Page 1
At year-end 1990, risk-based capital standards were implemented for U.S. commercial banks. The
new standards substantially changed U.S. regulatory standards for assessing bank capital adequacy,
by replacing simple flat-rate standards with standards that explicitly incorporated risk. This study
investigates whether the risk-based capital standards are improved measures of capital adequacy.
The relative merits of both the risk-based and former flat-rate capital standards are discussed. In
addition, brief histories of banks' regulatory capital ratios are used to compare the effectiveness
of the standards. The study concludes that the risk-based capital standards are an improvement
over the flat-rate capital standards they replaced.
The Bank and Thrift Crises — A Retrospective
by David S. Holland Page 16
The years since 1980 have been a tumultuous period for the U.S. banking and thrift industries
and their regulators. Recent improvements in profitability and declines in the number of bank
and thrift failures, however, give reason to beiieve that the worst may be over. The author uses
this respite to review what has transpired and to look ahead.
Commercial Real-Estate Problems: A Note on Changes in Collateral Values
Backing Real-Estate Loans Being Managed by the Federal Deposit Insurance
Corporation
by James L. Freundand Steven A. Seelig Page 26
The most recent economic dislocation to affect the banking industry is the major downturn of
commercial real-estate markets in many areas of the country. In this article the authors report the
results of a survey estimating the decline in collateral values for individual real-estate assets under
FDIC management.
Recent Developments Affecting Depository Institutions
by Benjamin B. Christopher Page31
This regular feature of the FD/C Banting Review con tains informarion on regulatory agency actions,
state legislation and regulation, and articles and studies pertinent to banking and deposit insurance
issues.
Risk-Based Capital Standards
Risk-Based Capital Standards
for Commercial Banks:
Improved Capital-Adequacy Standards?
by John P. O'Keefe'
In August 1988, the Board of Gov
ernors of the Federal Reserve
System agreed to adopt risk-
based capital standards for U.S. com
mercial and savings banks and bank
holding companies. The new stan
dards, which substantially changed
U.S. regulatory standards for assessing
bank capital adequacy, replaced
simple flat-rate standards with stan
dards thatexplicitly incorporated risk.
While well-run banks had their own
"risk-based" systems for allocating
capital, business plans had to be
revised to incorporate the new
regulatory standards. Interim mini
mum risk-based capital standards,
which allowed for a transitional
period, became effective at year-end
1990. The new standards became
fully effective at year-end 1992.
The primary purpose of this paper
is to assess the risk-based capital
standards as measures of capital ade
quacy. The paper concludes that the
risk-based capital standards are an im
provement over the former primary
and secondary capital constraints they
replaced. This paper first reviews the
reasons for bank capital requirements
and discusses the flaws inherent in
the previous primary and secondary
capital standards which were estab
lished in 1985. The next section ex
amines the motivation behind risk-
based capital standards and briefly
describes the new standards. Sub
sequently, factual information is
added to the theoretical discussions.
Brief histories of banks' risk-based
capitalization, as well as other capital-
adequacy measures, are used to assess
the standards as measures of bank
capital adequacy. Conclusions and
recommendations are presented in
the final section.
Bank Capital Adequacy
The subject of bank capital ade
quacy has received extensive treat
ment in the academic literature. '
One reason for this is that the topic is
intrinsically multifaceted: adequate
capital for what purposes and from
whose petspective? Once the relevant
functions of capital are established,
one can select those types of financial
instruments that best serve these
functions and define an appropriate
capital measure."
The primary function of bank capi
tal is to provide a cushion against los
ses, enabling banks to survive in
difficult economic times. This func
tion is served by equity capital, which
represents owners' investment in the
bank. In addition, general loan- and
lease-loss reserves, which banks have
"John P. O'Keefe is a financial economist in
the FDIC's Division of Research and Statistics.
The author would like to thank Gary Fissel of
the FDIC's Division of Research and Statistics
and Stephen Pfeifer of the Division of Super
vision for the useful information and comments
they provided.
The interim risk-based capital standards
established a minimum total risk-based capital
ratio of 7.25 percent. The final standards in
creased this minimum to 8 percent.
The same risk-based standards apply to
both commercial and savings banks. Historical
differences between commercial and savings
banks' financial reports make direct com
parisons difficult. For this reason, savings banks
were excluded from the analysis. In addition,
risk-based capital standards for savings associa
tions {thrifts! were adopted by the Office of
Thrift Supervision in 1989. A thorough discus
sion of thrift capital requirements is provided in
Elmer (1990).
' Regulators' use of the term "adequate"
versus "optimal" capital levels reflects the fact
that bank regulators seek to set minimally-
acceptable capital requirements for banks.
These minimums have historically been well
below those levels that the vast majority of
banks have found to be optimal.
In this discussion, the term capital is used
in its broadest sense to refer to all forms of
long-term corporate finance, debt and equity.
This broad definition is based upon the stand
ard delineation used in corporate finance litera
ture between "capital markets" and "money
markets." Financial instruments with long
original maturities (usually over one year) are
traded in capital markets, while instruments
with shorter original maturities arc traded in
money markets.
" Vojta (1973| contains a useful discussion of
the functions of bank capital.
Risk-Based Capital Standards
for Commercial Banks:
Improved Capital-Adequacy Standards?
by John P. O'Keefe'
In August 1988, the Board of Gov
ernors of the Federal Reserve
System agreed to adopt risk-
based capital standards for U.S. com
mercial and savings banks and bank
holding companies. The new stan
dards, which substantially changed
U.S. regulatory standards for assessing
bank capital adequacy, replaced
simple flat-rate standards with stan
dards thatexplicitly incorporated risk.
While well-run banks had their own
"risk-based" systems for allocating
capital, business plans had to be
revised to incorporate the new
regulatory standards. Interim mini
mum risk-based capital standards,
which allowed for a transitional
period, became effective at year-end
1990. The new standards became
fully effective at year-end 1992.
The primary purpose of this paper
is to assess the risk-based capital
standards as measures of capital ade
quacy. The paper concludes that the
risk-based capital standards are an im
provement over the former primary
and secondary capital constraints they
replaced. This paper first reviews the
reasons for bank capital requirements
and discusses the flaws inherent in
the previous primary and secondary
capital standards which were estab
lished in 1985. The next section ex
amines the motivation behind risk-
based capital standards and briefly
describes the new standards. Sub
sequently, factual information is
added to the theoretical discussions.
Brief histories of banks' risk-based
capitalization, as well as other capital-
adequacy measures, are used to assess
the standards as measures of bank
capital adequacy. Conclusions and
recommendations are presented in
the final section.
Bank Capital Adequacy
The subject of bank capital ade
quacy has received extensive treat
ment in the academic literature. '
One reason for this is that the topic is
intrinsically multifaceted: adequate
capital for what purposes and from
whose petspective? Once the relevant
functions of capital are established,
one can select those types of financial
instruments that best serve these
functions and define an appropriate
capital measure."
The primary function of bank capi
tal is to provide a cushion against los
ses, enabling banks to survive in
difficult economic times. This func
tion is served by equity capital, which
represents owners' investment in the
bank. In addition, general loan- and
lease-loss reserves, which banks have
"John P. O'Keefe is a financial economist in
the FDIC's Division of Research and Statistics.
The author would like to thank Gary Fissel of
the FDIC's Division of Research and Statistics
and Stephen Pfeifer of the Division of Super
vision for the useful information and comments
they provided.
The interim risk-based capital standards
established a minimum total risk-based capital
ratio of 7.25 percent. The final standards in
creased this minimum to 8 percent.
The same risk-based standards apply to
both commercial and savings banks. Historical
differences between commercial and savings
banks' financial reports make direct com
parisons difficult. For this reason, savings banks
were excluded from the analysis. In addition,
risk-based capital standards for savings associa
tions {thrifts! were adopted by the Office of
Thrift Supervision in 1989. A thorough discus
sion of thrift capital requirements is provided in
Elmer (1990).
' Regulators' use of the term "adequate"
versus "optimal" capital levels reflects the fact
that bank regulators seek to set minimally-
acceptable capital requirements for banks.
These minimums have historically been well
below those levels that the vast majority of
banks have found to be optimal.
In this discussion, the term capital is used
in its broadest sense to refer to all forms of
long-term corporate finance, debt and equity.
This broad definition is based upon the stand
ard delineation used in corporate finance litera
ture between "capital markets" and "money
markets." Financial instruments with long
original maturities (usually over one year) are
traded in capital markets, while instruments
with shorter original maturities arc traded in
money markets.
" Vojta (1973| contains a useful discussion of
the functions of bank capital.