Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%. The capital adequacy ratio measures a bank's capital in relation to its risk-weighted assets. The capital-to-risk-weighted-assets ratio promotes financial stability and efficiency in economic systems throughout the world.
- Basel III is an international regulatory accord that set out reforms meant to improve the regulation, supervision, and risk management in the banking sector.
- Because of the impact of the 2008 credit crisis, banks must maintain minimum capital requirements and leverage ratios.
- Under Basel III, a bank's tier 1 must be a minimum of 10.5% of its risk-weighted assets (RWA) and tier 2 must be 2%.
- The total minimum capital adequacy ratio of both tiers, also including the capital conservation buffer, is 12.5%.
Basel III Capital Adequacy Ratio Minimum Requirement
The capital adequacy ratio is calculated by adding tier 1 capital to tier 2 capital and dividing by risk-weighted assets. Tier 1 capital is the core capital of a bank, which includes equity capital and disclosed reserves. This type of capital absorbs losses without requiring the bank to cease its operations; tier 2 capital is used to absorb losses in the event of a liquidation.
As of 2020, under Basel III, a bank's tier 1 and tier 2 minimum capital adequacy ratio (including the capital conservation buffer) must be at least 12.5% of its risk-weighted assets RWA). That combines tier 1 and tier 2 requirements—the minimum tier 1 capital ratio is 10.5% and the minimum tier 2 is 2%. The capital conservation buffer recommendation is designed to build up banks' capital, which they could use in periods of stress.
The Basel III requirements were in response to the significant weakness in financial regulation that was revealed in the aftermath of the 2008 financial crisis, with regulators seeking to build up bank liquidity and limit leverage.
Basel III Example
For example, assume Bank A has $5 million in tier 1 capital and $3 million in tier 2 capital. Bank A loaned $5 million to ABC Corporation, which has 25% riskiness, and $50 million to XYZ Corporation, which has 55% riskiness.
Bank A has risk-weighted assets of $28.75 million ($5 million * 0.25 + $50 million * 0.55). It also has capital of $8 million, ($5 million + $3 million). Its resulting capital adequacy ratio is 27.83% ($8 million/$28.75 million * 100%). Therefore, Bank A attains the minimum capital adequacy ratio, under Basel III.
Basel III Minimum Leverage Ratio
Another of the major capital standards changes of the Basel III Accord was a reduction in excess leverage from the banking sector. For these purposes, banking leverage means the proportion of a bank's non-risk-weighted assets and its total financial capital. The Basel Committee decided on new leverage measurements and requirements because it was deemed "complementary to the risk-based capital framework, and ensures broad and adequate capture of both the on- and off-balance sheet leverage of banks."
Basel III builds on the structure of Basel II but brings in higher standards for capital and liquidity, therefore increasing the overseeing and risk management of the financial industry.
The Basel Committee introduced new legislation to target and limit the operations of the so-called systematically important financial institutions (SIFIs). These are the classic too-big-to-fail banks, only on a global scale. In the United States, such banks are subject to intensive stress testing and excess regulations. The Fed doubled the capital requirements and leverage ratio minimums for several SIFIs, including JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley, and Bank of New York Mellon.
The Basel III leverage requirements were set out in several phases. The first phase involved bank-level reporting to supervisors and regulators in January 2013. These reports establish uniform component measurements among affected institutions.
The second phase, public disclosure of leverage ratios, was originally set for voluntary implementation for January 2015, but ultimately delayed. Subsequent adjustment phases determined any calibrations or exceptions that were necessary. Current voluntary implementation is set for January 1, 2022.