What it means
The central idea is that a bank must fund a minimum share of its assets with capital rather than borrowed money, and that the share rises with how risky those assets are. A government bond carries a low risk weight and a speculative property loan a high one, so two banks with identical balance sheet totals can face very different capital requirements.
Basel III tightened both the numerator and the denominator of that calculation. It narrowed the definition of capital so that ordinary shares and retained earnings, known as common equity tier 1, carry most of the weight, and it required more of it relative to risk weighted assets.
Alongside the risk based ratio sit three simpler safeguards. A leverage ratio caps total borrowing regardless of risk weights, a liquidity coverage ratio requires enough easily sold assets to cover 30 days of outflows, and a net stable funding ratio pushes banks to fund long term lending with long term money.
This matters far beyond banking because capital rules shape the price and availability of credit. When a category of lending attracts a heavy risk weight, banks either charge more for it or lend less of it, which is felt directly by property developers, small businesses and anyone borrowing against unusual security.
Buffers are the part that trips people up. On top of the hard minimum sit a capital conservation buffer and, in some countries, a countercyclical buffer, and a bank that dips into them is not in breach but does face restrictions on dividends and bonuses until it rebuilds.
In practice
Real-world examples.
Example
A regional bank wants to grow its commercial property book but sits only 40 basis points above its combined capital requirement. Rather than raise equity in a weak market, it sells a portfolio of higher risk weighted loans to free up capacity for new lending.
Example
A treasury team swaps part of its holding of corporate paper for government bonds to improve the liquidity coverage ratio. The move costs yield but means the bank can demonstrate it would survive 30 days of deposit outflows without emergency funding.
Example
A bank's board cancels a planned share buyback after a stress test shows the capital ratio falling into the conservation buffer under a severe scenario. Distributions would have been restricted automatically in that case, so the board chose to act before the regulator did.
Think of it
“Basel III is banking regulation for safety-international rules for bank capital and liquidity.
Formula
Calculation
Common equity tier 1 ratio = common equity tier 1 capital / risk weighted assets
A mid sized bank holds $2,400,000,000 of common equity tier 1 capital and reports risk weighted assets of $30,000,000,000, giving a CET1 ratio of $2,400,000,000 / $30,000,000,000 = 8.0%. Basel III sets a minimum CET1 ratio of 4.5% plus a capital conservation buffer of 2.5%, so the effective requirement is 7.0%.
Required capital is 7.0% x $30,000,000,000 = $2,100,000,000, leaving a surplus of $2,400,000,000 - $2,100,000,000 = $300,000,000. If the bank then wrote another $5,000,000,000 of risk weighted lending, the requirement would rise to 7.0% x $35,000,000,000 = $2,450,000,000, which is more than it holds, so it would have to raise capital or slow the lending down.Case study
Seen in the real world.
The following is an illustrative and fictional example. Thameside Regional Bank, an invented lender, reported a healthy looking total capital ratio built largely on subordinated debt that had counted as capital under the older rules. As Basel III definitions phased in, much of that instrument stopped qualifying and the bank's common equity tier 1 ratio turned out to be far thinner than its headline number suggested.
The fictional management team had three options: raise equity, cut the dividend, or shrink the loan book. It chose a combination, raising a modest amount of new shares and stepping back from a fast growing but capital hungry development finance business.
Profits fell for two years, and the invented bank's shareholders were unhappy. When a downturn arrived, Thameside was one of the few lenders in its region still able to write new business, which its board came to regard as the return on that earlier discomfort.
Watch out
Common mistakes.
- Reading a capital ratio as a pile of cash sitting in a vault, when it actually describes how the bank's assets are funded.
- Comparing capital ratios across banks without checking whether risk weights come from internal models or the standardised approach.
- Assuming a bank inside its capital buffer is failing, when the buffer is designed to be used and simply triggers limits on payouts.
Questions
People also ask.
Does Basel III apply to my company if we are not a bank?
Not directly, though it shapes what your bank will lend, at what price, and against what security.
Why does capital quality matter as much as quantity?
Because ordinary shares absorb losses immediately while some older hybrid instruments only did so once a bank was already failing.
What is the leverage ratio for?
It is a backstop that limits total borrowing regardless of risk weights, catching the case where a model has understated risk.
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