What it means
Capital in this context means the money a bank's owners have at risk, which absorbs losses before depositors and other lenders are affected. The crisis showed that many banks held too little of it and that some of what they counted was not able to absorb losses when needed.
Basel III tightened both the quantity and the quality. It put the emphasis on common equity Tier 1 capital, which is essentially ordinary shares and retained profits, and set minimum ratios of that capital to the bank's risk-weighted assets.
Risk-weighted assets are the bank's loans and exposures scaled by how risky each is judged to be. A loan fully secured on government bonds carries a far smaller weight than an unsecured loan to a start-up, which is why the rules influence what kinds of lending banks pursue.
The framework also added two liquidity standards and a leverage ratio. The liquidity coverage ratio requires enough high-quality liquid assets to cover thirty days of stressed outflows, the net stable funding ratio pushes banks towards longer-term funding, and the leverage ratio caps total exposure relative to capital regardless of risk weights.
For a borrower the practical consequences are visible in pricing and structure. Facilities that are undrawn, long-dated or unsecured generally became dearer relative to drawn, shorter and secured ones, and banks became keener on deposits from the customers they lend to.
In practice
Real-world examples.
Example
A mid-market company is told its $25,000,000 undrawn revolving facility now carries a higher commitment fee. The bank explains that undrawn commitments consume capital and liquidity resources, so holding the option open has a measurable cost.
Example
A bank restructures its product set to favour lending secured on investment-grade receivables over unsecured working capital loans. The shift follows the risk weights applied under the implemented Basel III rules rather than any change in customer default rates.
Example
A corporate treasurer is offered a better loan margin in exchange for moving the company's main operating accounts to the lending bank. Stable operating deposits improve the bank's funding ratios, so the bank is willing to share part of that benefit.
Formula
Calculation
Common equity Tier 1 ratio = (common equity Tier 1 capital / risk-weighted assets) x 100.
Take a bank with common equity Tier 1 capital of $600,000,000 and risk-weighted assets of $6,000,000,000. The ratio is 600,000,000 / 6,000,000,000 = 0.10, and 0.10 x 100 = 10%.
The framework sets a minimum common equity Tier 1 requirement of 4.5% of risk-weighted assets plus a capital conservation buffer of 2.5%, giving 7% before any additional national or institution-specific add-ons. On $6,000,000,000 of risk-weighted assets, 7% is $420,000,000, so this bank holds $600,000,000 - $420,000,000 = $180,000,000 of common equity Tier 1 above that level and has room to grow its lending before needing to raise more capital.Case study
Seen in the real world.
Albury Precision Tools is an illustrative, fictional engineering company with a $30,000,000 revolving credit facility it draws on only twice a year for inventory builds. At renewal its bank proposes a lower committed amount with a higher fee on the undrawn portion.
In this fictional negotiation, the finance director asks the bank to explain the drivers and learns that both the capital against the commitment and the liquidity assumed to be drawn in stress make large idle facilities expensive to provide. Rather than paying for a facility that sits unused, Albury analyses five years of cash flow and finds its true peak need is nearer $18,000,000.
The illustrative outcome is a smaller committed facility of $20,000,000 plus an uncommitted accordion the bank will consider case by case. Albury's total cost of funding falls even though the headline margin rose, because it stopped paying for unused capacity.
Watch out
Common mistakes.
- Thinking Basel III only concerns banks, when its capital and liquidity costs are passed into the price and shape of ordinary business credit.
- Treating all capital as equivalent, when the framework deliberately prioritises common equity over hybrid instruments that failed to absorb losses in the crisis.
- Assuming a large committed facility is cheap because it is undrawn, when the commitment itself consumes bank resources.
Questions
People also ask.
What are risk-weighted assets in plain terms?
The bank's exposures scaled by how risky each one is judged to be, so riskier lending requires proportionally more capital.
Why do banks now compete so hard for operating deposits?
Because stable customer deposits count favourably in the liquidity and funding ratios, making them a cheap and useful source of funds.
Does Basel III apply automatically in every country?
No, it is a standard that national authorities implement in their own rules, with differences in timing and in the buffers they add.
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