# Externally Imposed Capital Requirements

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Capital requirements on banks are laws that force them to have certain amounts of capital on hand. Because a bank's bankruptcy has more extensive repercussions than the bankruptcies of other industries, the only US industry subject externally imposed capital requirements is the banking industry.

If, for example, an auto manufacturer becomes insolvent, its suppliers and workers are left with money owed. Traumatic as this is, the banking industry also handles its customers' money, which means that a bank's bankruptcy not only costs the bank, its employees and its suppliers, but also its customers.

## How the Laws Work

William F Hummel, author of the website "Money: What It Is, How It Works," explains capital requirements as the amount of capital a bank is legally required to maintain This is measured as a proportion of its total holdings, adjusted for the riskiness of those holdings. The total amount of capital on hand needs to be 8 percent of the risk-adjusted asset value, with at least 4 percent coming from Tier 1 sources and the remainder coming from Tier 2 sources.

Capital requirements are determined as a proportion of the risk-adjusted value of the bank's assets, not as a proportion of its total value. Risk-adjusted value is calculated in the following manner, with an exemplar in parentheses:

Multiply the total value of cash and government securities on hand by 0 (\$8m x 0 = 0). Multiply the total value of loans owed from other banks by 0.2 (\$20m x 0.2 = \$4m) Multiply the total value of loans owed by mortgage holders by 0.5 (\$20m x 0.5 = \$10m) Multiply the total value of loans ordinary loans and loans secured by letters of credit by 1 (\$50m x 1 = \$50m)