Regulatory capital ensures banks can absorb losses while continuing to serve the economy, evolving from simple balance‑sheet residuals to risk‑sensitive frameworks under Basel III that cover credit, counterparty, market, and off‑balance sheet risks comprehensively. Capital adequacy today blends risk‑weighted requirements with leverage and liquidity backstops, using standardized and internal model approaches bounded by output floors to reduce unwarranted variability and arbitrage.
Bank capital: residual concept
In accounting terms, bank capital is the residual interest in assets after deducting liabilities, representing shareholder funds available to absorb unexpected losses before creditors and depositors are affected. Regulatory frameworks refine this into tiers of capital, emphasizing high‑quality Common Equity Tier 1 (CET1) as the most reliable loss‑absorbing layer in stress.
Why banks need capital
Capital protects depositors, sustains confidence, and provides a buffer against unexpected losses from credit, market, operational, and liquidity shocks, reducing the probability of failure and systemic contagion. Adequate capital also constrains leverage, aligns incentives for prudent risk‑taking, and supports ongoing access to funding across cycles.
Should regulators set minimums?
Regulatory minimums counter collective action problems and races to the bottom, ensuring a consistent safety baseline across institutions and jurisdictions. Post‑crisis reforms complemented risk‑weighted minima with a leverage ratio backstop and buffers to enhance comparability and resilience, addressing weaknesses revealed during the GFC.
Basel III capital regulation
Basel III raised the quantity and quality of capital, prioritized CET1, introduced a leverage ratio, and added conservation and countercyclical buffers to manage cyclical risk and improve loss absorbency. It also added systemic surcharges, enhanced disclosure, and tightened modeling constraints via standardized approaches and output floors to limit variability of risk‑weighted assets.
Standardized approach: credit risk
Under the standardized approach (SA), exposures are assigned risk weights by asset class and credit quality, with jurisdictions optionally using recognized ECAI ratings subject to supervisory criteria and due‑diligence overlays. Risk‑weighted assets are calculated net of specific provisions, with securitizations addressed under dedicated standards and counterparty exposures measured via separate CCR rules.
Off‑balance sheet items
Off‑balance sheet items are converted to credit exposure equivalents using credit conversion factors (CCFs) and then risk‑weighted in line with the counterparty and instrument class. Conversion factors reflect the likelihood that a commitment or guarantee becomes an on‑balance sheet exposure, ensuring OBS risks are capitalized comparably to funded positions.
Total counterparty risk
Counterparty credit risk (CCR) is the bilateral risk of loss that a counterparty defaults before final settlement, arising in derivatives, securities financing, and long‑settlement transactions. Basel III further requires capital for credit valuation adjustment (CVA) risk, recognizing losses from deterioration in counterparty credit quality beyond default‑only measures historically used.
External credit assessments
Where permitted, banks may use eligible ECAI ratings to assign risk weights in the SA, subject to supervisory recognition, consistent nomination, and safeguards to avoid mechanistic reliance. Supervisors require due diligence that can increase, but not decrease, the base risk weight implied by external ratings if higher‑risk characteristics are identified.
Issue rating vs issuer rating
Basel standards distinguish between issue‑specific ratings and issuer‑level ratings, applying the issue rating to the rated instrument and defaulting to issuer or unrated treatment where appropriate, consistent with supervisory nomination and eligibility rules. Covered bonds and similar instruments use issue ratings with floors and mapping tables, while unrated exposures follow standardized risk‑weight grids and due‑diligence requirements.
Credit risk mitigation
Recognized CRM techniques—such as eligible financial collateral, guarantees, and netting—reduce exposure values or adjust risk weights, subject to operational, legal enforceability, and haircuts calibrated by volatility and liquidity. For CCR, collateral, margining, and netting agreements directly affect exposure at default and CVA, with standardized or model‑based approaches reflecting these mitigants.
Internal Ratings‑Based (IRB) approach
The IRB approach permits the use of internal estimates for probability of default (PD), loss given default (LGD), exposure at default (EAD), and maturity (M), subject to supervisory approval and floors, with increased constraints under final Basel III reforms. Output floors now cap the capital benefit from models by referencing standardized approach calculations, enhancing comparability and limiting variability.
Capital for market risk: scope
Market risk capital requirements cover risks in the trading book, with a clearer boundary to reduce arbitrage between banking and trading books and to align with banks’ risk management practices. The framework specifies standardized and internal model approaches, governance expectations, and disclosure to ensure comprehensive capture of trading risk.
Measuring market risk capital
Basel’s fundamental review of the trading book (FRTB) replaces VaR with expected shortfall, introduces risk factor eligibility tests, and applies varying liquidity horizons to better capture tail risk and illiquidity. The revised standardized approach and internal models approach include stringent back‑testing, P&L attribution, and desk‑level approval processes to ensure credible, risk‑sensitive capital.
Interest rate risk measurement
Within market risk, interest rate risk in the trading book is capitalized through the FRTB framework’s risk class for interest rates using expected shortfall and liquidity horizons across curves and buckets. Separately, interest rate risk in the banking book (IRRBB) is captured under Pillar 2 expectations, with supervisors requiring measurement, monitoring, and capital against outlier exposures where relevant.
Putting it all together
Capital adequacy under Basel III now integrates higher‑quality capital, risk‑sensitive RWA via SA/IRB bounded by output floors, explicit CCR and CVA coverage, OBS conversion, and robust trading book charges under FRTB, complemented by leverage and supervisory overlays. These elements collectively reduce variability, curb excessive leverage, and enhance resilience, while preserving comparability and transparency across jurisdictions.
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