Regulatory capital is the capital that financial institutions, such as banks and insurance companies, are mandated by regulatory agencies to maintain to absorb potential losses and operate safely and soundly. This capital helps protect depositors, maintain market confidence, and prevent systemic risks. Regulatory capital comprises several components, including Tier 1 capital (core capital) and Tier 2 capital (supplementary capital). Tier 1 capital includes common equity and disclosed reserves, which are considered the most robust form of capital due to their ability to absorb losses. Tier 2 capital encompasses subordinated debt and hybrid capital instruments.
For example, if a bank encounters unforeseen financial losses, its regulatory capital acts as a buffer, preventing insolvency and protecting the institution's stakeholders. Additionally, regulatory capital requirements vary by jurisdiction and are established by bodies such as the Basel Committee on Banking Supervision. Adhering to these requirements is essential for a financial institution to operate legally and maintain its operating license. Non-compliance can result in penalties or restrictions from regulatory authorities.