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 strong capitalization and better financial resilience of banks throughout the world to resist economic and financial shocks and crises, such as the global recession that hit in 2008. With higher capitalization, banks can better withstand episodes of financial stress in the economy.
- 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, Common Equity Tier 1 must be at least 4.5% of risk-weighted assets (RWA) while Tier 1 capital must be at least 6% and total capital must be at least 8.0%.
- The total minimum capital adequacy ratio of both tiers, also including the capital conservation buffer, is 10.5%.
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 10.5% of its risk-weighted assets RWA). That combines the total capital requirement of 8% with the 2.5% capital conservation buffer. 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 total capital adequacy ratio is 27.83% ($8 million/$28.75 million * 100), and its Tier 1 ratio is 17.39% ($5 million/$28.75 million * 100). Therefore, Bank A attains the minimum capital adequacy ratios, 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 capital measure and its exposure measure. The Basel Committee decided on new leverage measurements and requirements because it was "of the view that a simple leverage ratio framework is critical and complementary to the risk-based capital framework and that the leverage should adequately capture both the on- and off-balance sheet sources of banks’ leverage."
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 global systemically important banks (G-SIBs), also known as systemically 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 issued supplementary leverage ratio minimums of 3% for banks with over $250 billion in consolidated total assets and 5% for banks with over $700 billion, including SIFIs such as 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 that began in 2013. 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.