Basel Capital

Basel capital refers to the Basel Accords — a series of international regulatory frameworks, most recently Basel III (agreed 2010, implemented 2013+), that establish minimum capital-adequacy standards for banks. These standards are agreed upon by central banks and financial regulators of the Group of Twenty (G20) nations and adopted globally.

History of Basel

Basel I (1988): Created after bank failures in the 1980s. Set a minimum capital ratio of 8%. Introduced the concept of risk-weighted-assets — different assets carry different risk weights. A Treasury bond (0% weight) requires no capital; a corporate loan (100% weight) requires 8% capital.

Basel II (2004): More nuanced. Allowed banks to use internal models to estimate risk weights rather than applying fixed weights. Introduced capital charges for operational-risk. Unfortunately, banks’ models underestimated risk, contributing to the 2008 crisis.

Basel III (2010+): Post-2008 response. Stricter capital requirements, higher quality capital, new liquidity and leverage ratios. Distinguishes Tier-1-capital (common equity, retained earnings) from Tier-2-capital (subordinated debt). Added liquidity-coverage-ratio (can a bank meet 30 days of outflows?) and leverage-ratio (non-risk-weighted backstop).

Basel III minimum capital requirements

Common Equity Tier 1 (CET1): 4.5% of risk-weighted assets.

• This is core equity capital: stock, retained earnings. Highest quality.

Tier 1 capital: 6%.

• CET1 plus Additional Tier 1 (AT1): contingent convertible bonds.

Total capital: 8%.

• Tier 1 + Tier 2 (subordinated debt, loan loss reserves).

Additional buffers:

• Capital conservation buffer: 2.5% above minimum, mandatory. Below it, restrictions on distributions (dividends, share buybacks).
• Counter-cyclical buffer: 0-2.5%, discretionary by national regulators. Adds capital during booms to build buffers for downturns.
• G-SIB surcharge: 1-3.5% for systemically important banks.

Example: A G-SIB bank is required to hold:

• 4.5% CET1 (minimum)
• +2.5% CET1 (conservation buffer)
• +1% CET1 (G-SIB surcharge)
• +2.5% CET1 (counter-cyclical buffer, in boom times) = 10.5% CET1 total (~13-14% total capital with Tier 2).

Risk-weighted assets

A key concept in Basel is risk-weighted-assets: not all assets are equally risky, so they require different capital.

Risk weights under Basel III:

• US Treasury bonds: 0% → $100M in Treasuries requires $0 capital.
• AAA-rated corporate bonds: 20% → $100M in AAA bonds requires $1.6M capital (at 8% total capital ratio).
• BBB-rated corporate bonds: 100% → $100M in BBB bonds requires $8M capital.
• Mortgages: 35% (prime); 100% (subprime).
• Corporate loans: 100%.
• Equity holdings: 300-400%.

The weighting reflects probability of default and loss given default.

Liquidity standards (Basel III addition)

Post-2008, Basel III added liquidity requirements because even well-capitalized banks failed when funding dried up (funding risk).

Liquidity Coverage Ratio (LCR): A bank must hold high-quality liquid assets sufficient to cover 30 days of stressed outflows (deposits fleeing, funding markets freezing). Minimum 100%.

Net Stable Funding Ratio (NSFR): Over one year, available funding must cover required funding. Prevents overreliance on short-term funding.

These ensure banks can survive funding shocks, not just credit losses.

Leverage ratio

Leverage-ratio is a non-risk-weighted backstop: capital / total assets (not risk-weighted). Minimum is 3-5%.

This prevents the kind of leverage used by investment banks pre-2008. A bank cannot use models to argue risks are low; the simple leverage ratio is a hard cap.

Challenges with Basel capital

Model risk. Risk weights rely on models of default probability and loss given default. If models are wrong, capital is insufficient. Banks’ models in 2007 said mortgage credit risk was low; in reality, it was high. Basel IV (“Basel III Endgame”) tightens restrictions on banks’ models.

Pro-cyclicality. In booms, defaults are low, risk weights are low, banks need less capital. They lend more, causing bubbles. In busts, defaults spike, risk weights are high, banks need more capital, but they cannot raise it (credit freeze). Basel III counter-cyclical buffer tries to address this.

Standardized weights. If you use simplified risk weights (not internal models), a bank with excellent underwriting pays the same capital as a reckless one. Incentive misalignment.

Complexity. The framework is complex; large banks employ hundreds of people to manage it.

Despite these challenges, Basel capital standards have improved financial stability since 2008. No major bank failures have occurred in post-Basel III periods (pre-COVID), and the 2020 pandemic was handled without banking crises.

Global adoption

Basel standards are adopted by central banks globally:

• US: Federal Reserve, OCC, FDIC.
• EU: European Banking Authority, national regulators.
• UK: Bank of England Prudential Regulation Authority.
• Japan: Financial Services Agency.
• And 150+ other jurisdictions.

Compliance is mandatory for all banks in these jurisdictions. Non-compliance results in restrictions (cannot grow, cannot pay dividends) and fines.

See also