What Is A Risk-Based Capital Requirement?

What Is a Risk-Based Capital Requirement?
Risk-based capital requirement refers to a rule that establishes minimum regulatory capital for financial
institutions. Risk-based capital requirements exist to protect financial firms, their investors, their clients,
and the economy as a whole. These requirements ensure that each financial institution has enough
capital on hand to sustain operating losses while maintaining a safe and efficient market.
Understanding Risk-Based Capital Requirement

Risk-Based Capital (RBC) is a method of measuring the minimum amount of capital appropriate for a
reporting entity to support its overall business operations in consideration of its size and risk profile. RBC
limits the amount of risk a company can take. It requires a company with a higher amount of risk to hold
a higher amount of capital. Capital provides a cushion to a company against insolvency. RBC is intended
to be a minimum regulatory capital standard and not necessarily the full amount of capital that an
insurer would want to hold to meet its safety and competitive objectives. In addition, RBC is not
designed to be used as a stand-alone tool in determining financial solvency of an insurance company;
rather it is one of the tools that give regulators legal authority to take control of an insurance company.
Before RBC was created, regulators used fixed capital standards as a primary tool for monitoring the
financial solvency of insurance companies. Under fixed capital standards, owners are required to supply
the same minimum amount of capital, regardless of the financial condition of the company. The
requirements required by the states ranged from $500,000 to $6 million and was dependent upon the
state and the line of business that an insurance carrier wrote. Companies had to meet these minimum
capital and surplus requirements in order to be licensed and write business in the state. As insurance
companies changed and grew, it became clear that the fixed capital standards were no longer effective
in providing a sufficient cushion for many insurers.
The NAIC’s RBC regime began in the early 1990s as an early warning system for U.S. insurance
regulators. The adoption of the U.S. RBC regime was driven by a string of large-company insolvencies
that occurred in late 1980s and early 1990s. The NAIC established a working group to look at the
feasibility of developing a statutory risk-based capital requirement for insurers. The RBC regime was
created to provide a capital adequacy standard that is related to risk, raises a safety net for insurers, is
uniform among the states, and provides regulatory authority for timely action.
Risk-based capital requirements are now subject to a permanent floor, as per a rule adopted in June
2011 by the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal
Reserve System, and the Federal Deposit Insurance Corporation (FDIC). In addition to requiring a
permanent floor, the rule also provides some flexibility in risk calculation for certain low-risk assets.
The Collins Amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act imposes
minimum risk-based capital requirements for insured depository institutions, depository institutions,
holding firms, and non-bank financial companies that are supervised by the Federal Reserve.
Under the Dodd-Frank rules, each bank is required to have a total risk-based capital ratio of 8% and a
tier 1 risk-based capital ratio of 4.5%. A bank is considered “well-capitalized” if it has a tier 1 ratio of 8%
or greater and a total risk-based capital ratio of at least 10%, and a tier 1 leverage ratio of at least 5%.
U.S. banks and banking organizations are subject to a dual framework of capital Regulation. A set of
leverage requirements specifies the minimum amount of tier 1 capital that banks and banking
organizations must hold as a percentage of balance sheet Assets. For insured banks, the leverage
requirements are an integral component of the statutory framework of Prompt Corrective Action (PCA)
mandated in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The leverage
and PCA requirements are unaffected by this final rule.
Risk-based capital requirements complement the leverage requirements by requiring capital for risks
that are either not reflected on the balance sheet, or that pose materially more risk than the leverage
requirements were designed to address. Current Risk-based capital rules involve converting the notional
amounts of off-balance sheet risks to on-balance sheet equivalents using defined conversion factors,
and then requiring capital for the resulting on-balance sheet equivalents, and for all other balance-sheet
items, using predefined risk buckets. Current rules also prescribe separate capital requirements for
market risk, which apply to a small number of U.S. banks.
3 approaches to measure operational risk

Here we’ll explain the different approaches to measuring operational risk in an organization. According
to the Basel Committee, there are three ways to measure operational risk: the basic indicator approach
(BIA), the standard approach (SA) and the advanced measurement approach (AMA).
1. Basic Indicator approach for measuring operational risk:

The basic indicator approach is much simpler than the other techniques for measuring operational risk
and is therefore recommended for small financial entities whose operations are not very complex.
This method calculates the operational risk for the entire organization and then assigns the result to the
operational lines. The basic indicator is measured as a percentage of gross income over that of the
preceding three years.
There are several reasons why this indicator is calculated through gross income. First of all, it is
verifiable. Secondly, because it is immediately available and also because it is a counter-cyclical measure
that helps to reliably measure the size of activities.
2. Standard approach to measuring operational risk (SA):

According to this method for measuring operating risk, banks’ activities are divided into eight lines of
business: corporate finance, sales and trading, retail banking, commercial banking, payments and
settlements, agency services, asset management and retail brokerage.
Within each line of business, gross revenue serves as an indicator to measure the scale of commercial
operations and, therefore, to calculate the possible exposure to operational risk in each line.
It is calculated by taking the three-year average of the sum of the regulatory capital charges for each
operating line in each year.
To use the standard approach, a bank must meet certain requirements:
I) Both the board of directors and senior management must be involved in overseeing the
operational risk management framework.
II) It must have a solid operational risk management system that is implemented throughout
the company.
III) It must have sufficient resources to use this approach in the main lines of business, as well
as in the areas of control and auditing.
3. Advanced measurement approach (AMA):

Out of the three approaches to measuring operational risk, this is the most sophisticated method. With
the AMA model, banks can create their own empirical model to quantify the capital required for
operational risk.
An AMA framework should include the use of four quantitative elements for its development: internal
loss data, external data, scenario and business environment analysis, or internal control factors.
Among the AMA models, there are three different types of methodologies: internal measurement
approach (IMA), loss distribution approach (LDA) and scorecards.
At CERO, the advanced measurement approach (AMA) is the one we use to estimate operational risk
capital based on the loss distribution approach (LDA). This approach allows us to establish continuous
improvement systems, predict expected losses for the organization over a period of time, define loss
indicators and thresholds, and create scenarios to simulate catastrophic events.

What Is A Risk-Based Capital Requirement?

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What Is a Risk-Based Capital Requirement?

Understanding Risk-Based Capital Requirement

3 approaches to measure operational risk

1. Basic Indicator approach for measuring operational risk:

2. Standard approach to measuring operational risk (SA):

3. Advanced measurement approach (AMA):

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