These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent.
From the 1880s to the end of the First World War, the capital-to-assets ratios globally declined sharply, before remaining relatively steady during the XXth century.
[1] A key part of bank regulation is to make sure that firms operating in the industry are prudently managed.
The aim is to protect the firms themselves, their customers, the government (which is liable for the cost of deposit insurance in the event of a bank failure) and the economy, by establishing rules to make sure that these institutions hold enough capital to ensure continuation of a safe and efficient market and are able to withstand any foreseeable problems.
Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a bank's capital eroded by the yearly inflation rate.
Examples of national regulators implementing Basel include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy.
In the United States the primary regulators implementing Basel include the Office of the Comptroller of the Currency and the Federal Reserve.
In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB).
In India, the Tier 1 capital is defined as "'Tier I Capital' means "owned fund" as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a systemically important non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;" (as per Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007) In the context of NBFCs in India, the Tier I capital is nothing but net owned funds.
Owned funds stand for paid up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any.
A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago.
Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future.