Credit risk is the dominant source of risk for banks and leasing companies.  The amount of capital in relation to risk weighted assets required by regulatory authorities that financial institutions must hold to ensure their ability to provide financial services to the public while meeting their short-term and long-term obligations and to absorb any losses that they may incur is capital adequacy.  Regulatory-mandated risk-based capital adequacy requires financial institutions to hold capital reserves to provide protection against the credit risk inherent in their credit operations and market activities and the operational risk of the institutions.

Federal Reserve and Basel III Capital Requirements for Financial Institutions
1-Jan-15 1-Jan-16 1-Jan-17 1-Jan-18 1-Jan-19
Capital Conversion Buffer 0.625% 1.25% 1.875% 2.5%
Minimum Common Equity Tier 1 4.5%    4.5%   4.5%    4.5% 4.5%
Minimum Tier 1 Capital* 6.0%    6.0%   6.0%    6.0% 6.0%
Minimum Total Capital† 8.0%    8.0%   8.0%    8.0% 8.0%
* 4.5% Common Equity Tier 1 Capital + 1.5% Additional Tier 1Capital
† 6.0% Tier 1 Capital + 2.0% Tier 2 Capital

Financial institutions use the probability of default/loss given default methodology (PD/LGD) to determine the expected credit loss rate to apply to their risk assets and calculate their regulatory capital requirement.  They rely on their own estimates of the PD, LGD, and EAD parameters for measuring the credit quality of their loans and leases and the allowance for loan and lease losses (ALLL).

Optimizing the management of regulatory capital, which is one of the primary objectives of the ALM function, can be considered only in conjunction with credit risk management.  Regulatory capital has a major impact on the provision of finance, where the principal purpose of regulatory capital requirements together with the liquidity standards imposed on financial institutions is to influence their appetite for credit risk.

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