The business of banking involves taking and managing a variety of risks. Major risks facing banking institutions include those listed in table 1. Changes in the banking industry and financial markets have increased the complexity of banking risks. Banking assets have become more concentrated among a small number of very large, complex banking organizations that operate across a wide range of financial products and geographic markets. Due to these organizations’ scale and roles in payment and settlement systems and in derivatives markets, a significant weakness in any one of these entities could have severe consequences for the safety and soundness of the banking system and broader economy. As a result, federal banking regulators have adopted a risk-focused approach to supervision that emphasizes continuous monitoring and assessment of how banking organizations manage and control risks. Faced with such risks, banks must take protective measures to ensure that they remain solvent. For example, banks are required to maintain an allowance for loan and lease losses to absorb estimated credit losses. Banks must also hold capital to absorb unexpected losses. Capital is generally defined as a firm’s long-term source of funding, contributed largely by a firm’s equity stockholders and its own returns in the form of retained earnings. In addition to absorbing losses, capital performs several other important functions: it promotes public confidence, helps restrict excessive asset growth, and provides protection to depositors and the federal deposit insurance fund. Capital adequacy is fundamental to the safety and soundness of the banking system, and a bank’s capital position can affect its competitiveness in several ways. Strong capital enhances a bank’s access to liquidity on favorable terms and ensures that it has the financial flexibility to respond to market opportunities. However, holding capital imposes costs on banks, because equity is a more costly form of financing than debt. Capital adequacy regulation seeks to offset banks’ disincentives to hold capital, which result in part from access to federal deposit insurance. In addition, capital adequacy requirements for large banks are especially important because of the systemic risks these banks can pose to the banking system. Regulators require banks to maintain certain minimum capital requirements and generally expect banks to hold capital above these minimums, commensurate with their risk exposure. However, requiring banks to hold more capital may reduce the availability of bank credit and reduce returns on equity to shareholders. In addition, capital requirements that are too high relative to a bank’s risk profile may create an incentive for a bank to hold more high-risk assets, in order to earn a market-determined return on capital. Banking regulators attempt to balance safety and soundness concerns with the costs of holding higher capital. Four federal banking regulators supervise the nation’s banks and thrifts, and each serves as primary federal regulator over certain types of institutions: OCC supervises national (i.e., federally chartered) banks. Many of the nation’s largest banks are federally chartered. The Federal Reserve supervises bank holding companies, including financial holding companies, as well as state chartered banks that are members of the Federal Reserve System (state member banks). Many of the largest banking organizations are part of holding company structures—companies that hold stock in one or more subsidiaries—and the Federal Reserve supervises bank holding company activities. FDIC serves as the deposit insurer for all banks and thrifts and has backup supervisory authority for all banks it insures. It is also the primary federal regulator of state chartered banks that are not members of the Federal Reserve System (state nonmember banks). OTS regulates all federally insured thrifts, regardless of charter type, and their holding companies. Under the dual federal and state banking system, state chartered banks are supervised by state regulatory agencies in addition to a primary federal regulator. In addition to these banking regulators, SEC supervises broker- dealers. In 2004, SEC established a voluntary, alternative net capital rule for broker-dealers whose ultimate holding company consents to groupwide supervision as a consolidated supervised entity. The rule requires consolidated supervised entities to compute and report capital adequacy measures consistent with Basel standards. The U.S. regulatory capital framework includes both risk-based and leverage minimum capital requirements. Both banks and bank holding companies are subject to minimum leverage standards, measured as a ratio of tier 1 capital to total assets. The minimum leverage requirement is between 3 and 4 percent, depending on the type of institution and a regulatory assessment of the strength of its management and controls. Leverage ratios are a commonly used financial measure of risk. Greater financial leverage, as measured by higher proportions of debt relative to equity (or lower proportions of capital relative to assets), increases the riskiness of a firm. During the 1980s, regulators became concerned that simple capital-to-assets leverage measures required too much capital for less risky assets and not enough for riskier assets. Another concern was that such measures did not require capital for growing portfolios of off- balance sheet items. In response to these concerns, regulators from the United States and other countries adopted Basel I, an international framework for risk-based capital that required minimum risk-based capital ratios of 4 percent for tier 1 capital to risk-weighted assets and 8 percent for total capital to risk-weighted assets. By 1992, U.S. regulators had fully implemented Basel I; and in 1996, they and supervisors from other Basel Committee member countries amended the framework to include explicit capital requirements for market risk from trading activity. The use of a leverage requirement was continued after the introduction of risk-based capital requirements as a cushion against risks not explicitly covered in the risk-based capital requirements. The greater level of capital required by the risk-based or leverage capital calculation is the binding overall minimum requirement on an institution. Furthermore, the Federal Deposit Insurance Corporation Improvement Act of 1991 created a new supervisory framework known as prompt corrective action (PCA) that links supervisory actions closely to a bank’s capital ratios. PCA, which applies only to banks, not bank holding companies, has become a primary regulatory influence over bank capital levels. PCA requires regulators to take increasingly stringent forms of corrective action against banks as their leverage and risk-based capital ratios decline. The purpose is to ensure that timely regulatory action is taken to address problems at financially troubled banks in order to prevent bank failure or minimize resulting losses. There is a strong incentive for banks to qualify as “well-capitalized,” which is the highest capital category and exceeds the minimum capital requirements, because banks deemed less than well-capitalized have restrictions or conditions on certain activities and may also be subject to mandatory or discretionary supervisory actions. Regulatory officials noted that the PCA well- capitalized standards are the de facto minimum regulatory capital requirements for banks and that virtually all banks maintain capital levels that meet the well-capitalized criteria. As shown later in this report in figure 4, the required capital ratios for the well-capitalized category are: (1) a total risk-based capital ratio of 10 percent or greater, (2) a tier 1 risk- based capital ratio of 6 percent or greater, and (3) a leverage ratio of 5 percent or greater. Regulatory officials generally agree that while Basel I continues to be an adequate capital framework for most banks, it has become increasingly inadequate for supervising the capital adequacy of the nation’s largest, most complex banking organizations. Many of these banks have developed advanced risk measurement techniques that have created a growing gap between the regulatory capital framework and banks’ internal economic capital allocation methods. Regulators have sought to encourage the use of such methods as an element of strong risk management and because such methods may provide useful input to the supervisory process. Basel II is intended to address the shortcomings of Basel I and further encourage banks to develop and maintain a disciplined approach to risk management. When established internationally in 1988, Basel I represented a major step forward in linking capital to risks taken by banking organizations, strengthening banks’ capital positions, and reducing competitive inequality among international banks. Regulatory officials have noted that Basel I continues to be an adequate capital framework for most banks, but its limitations make it increasingly inadequate for the largest and most internationally active banks. As implemented in the United States, Basel I consists of five broad credit risk categories, or risk weights (table 2). Banks must hold total capital equal to at least 8 percent of the total value of their risk-weighted assets and tier 1 capital of at least 4 percent. All assets are assigned a risk weight according to the credit risk of the obligor and the nature of any qualifying collateral or guarantee, where relevant. Off-balance sheet items, such as credit derivatives and loan commitments, are converted into credit equivalent amounts and also assigned risk weights. The risk categories are broadly intended to assign higher risk weights to—and require banks to hold more capital for—higher risk assets. However, Basel I’s risk-weighting approach does not measure an asset’s level of risk with a high degree of accuracy, and the few broad categories available do not adequately distinguish among assets within a category that have varying levels of risk. For example, although commercial loans can vary widely in their levels of credit risk, Basel I assigns the same 100 percent risk weight to all these loans. Such limitations create incentives for banks to engage in regulatory capital arbitrage—behavior in which banks structure their activities to take advantage of limitations in the regulatory capital framework. By doing so, banks may be able to increase their risk exposure without making a commensurate increase in their capital requirements. For example, because Basel I does not recognize differences in credit quality among assets in the same category, banks may have incentives to take on high-risk, low-quality assets within each broad risk category. As a result, the Basel I regulatory capital measures may not accurately reflect banks’ risk profiles, which erodes the principle of risk- based capital adequacy that the Basel Accord was designed to promote. In addition, Basel I recognizes the important role of credit risk mitigation activities only to a limited extent.