What it means
A bank funds its lending mostly with other people's money, in the form of deposits, bonds and short-term borrowing. Capital is the slice funded by shareholders and retained profits, and it is the buffer that absorbs losses first.
The Basel Accords set a minimum size for that buffer relative to how risky the bank's assets are. The rules matter far beyond banking itself.
Capital requirements shape how much credit banks can extend, what it costs and which borrowers look attractive, so a change agreed in Basel eventually shows up in the price of a business overdraft. There have been three main rounds.
Basel I in 1988 introduced a crude risk-weighting system, Basel II in 2004 allowed banks to use their own risk models and added a charge for operational risk, and Basel III, agreed after the 2008 crisis, raised the quality of capital and added liquidity and leverage requirements. Most finance teams meet the accords only through their effects.
Loan covenants, pricing, and a bank's willingness to lend against particular collateral all trace back to how much capital the bank must set aside for that exposure. An important nuance is that Basel is not law in itself.
The committee has no legal power, so each jurisdiction adopts, delays or modifies the text, which is why the same bank can face materially different rules in different countries.
In practice
Real-world examples.
Example
A manufacturer asks its bank for a $6,000,000 unsecured facility and is offered a secured one instead at a lower margin. The relationship manager explains that secured lending attracts a lower risk weight, so the bank ties up less capital and can price the deal more keenly.
Example
A regional bank announces a rights issue to raise fresh equity ahead of a planned acquisition. Analysts read it as a capital adequacy move rather than a growth signal, because the acquired loan book would otherwise push the bank close to its regulatory floor.
Example
A property developer finds that construction lending has become scarcer and dearer across the whole market at once. The cause is not its own credit quality but a supervisory decision to apply higher risk weights to development exposures.
Formula
Calculation
Capital adequacy ratio = Regulatory capital / Risk-weighted assets, with a long-standing total minimum of 8%.
Consider a mid-sized commercial bank holding $150,000,000 of risk-weighted assets against $12,000,000 of qualifying capital. The ratio is 12,000,000 / 150,000,000 = 0.08, or exactly 8%, so it sits on the minimum with nothing to spare. The bank now writes $25,000,000 of new corporate loans carrying a 100% risk weight, lifting risk-weighted assets to $175,000,000. The same $12,000,000 of capital now gives 12,000,000 / 175,000,000 = 0.0686, or 6.9%, which breaches the minimum. To support $175,000,000 at 8% the bank needs 175,000,000 x 0.08 = $14,000,000, so it must raise a further $2,000,000 of capital or lend less.Case study
Seen in the real world.
Meridian Coast Bank is a fictional institution invented purely for this illustrative example. It ran for years with a comfortable total capital ratio of 11%, well above the 8% floor, and its board treated capital as a background compliance matter rather than a strategic constraint.
Growth then concentrated in a single area: unsecured lending to small businesses, which carried the heaviest risk weights on the book. Within eight quarters risk-weighted assets had grown by more than a third while retained profits grew only modestly, and the ratio drifted down to 8.6%.
In this illustrative account the board faced a choice it had never had to make: raise equity at a poor share price, sell a portfolio of loans, or stop writing the most profitable business it had. It chose a partial loan sale, and afterwards made capital consumption a standing item in every lending approval.
Watch out
Common mistakes.
- Assuming the Basel Accords are binding international law, when they are recommendations that only bite once a national regulator adopts them.
- Treating the 8% minimum as the level banks actually run at, when supervisors, buffers and market expectations push real ratios much higher.
- Confusing capital with cash or liquidity, when capital is about the funding mix on the liabilities side and liquidity is about being able to meet payments as they fall due.
Questions
People also ask.
Who writes the Basel Accords?
The Basel Committee on Banking Supervision, hosted by the Bank for International Settlements, made up of banking supervisors from major economies.
Do the accords apply to every bank?
In principle they target internationally active banks, but most countries apply a version of them to domestic banks too, often in simplified form.
Why should a non-bank business care?
Because capital rules determine how much credit is available and at what price, so they influence overdraft pricing, covenant terms and appetite for lending against particular assets.
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