A:

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 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 liquidation.

As of 2017, under Basel III, a bank's tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5%. The capital conservation buffer recommendation is designed to build up banks' capital, which they could use in periods of stress.

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."

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 eight SIFIs: 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 set for January 2015. Two subsequent adjustment phases, one in 2017 and another in 2018, determine any calibrations or exceptions that are necessary.

(For related reading, see: Understanding the Basel III International Regulations.)

RELATED FAQS
  1. What does a high capital adequacy ratio indicate?

    Learn about the capital adequacy ratio, what the ratio measures, how it is calculated, and what it means when a bank has ... Read Answer >>
  2. What Is the Difference between Tier 1 Capital and Tier 2 Capital?

    Tier 1 capital is a bank's core capital, whereas tier 2 capital is a bank's supplementary capital. Read Answer >>
  3. How do I calculate the capital to risk weight assets ratio for a bank in Excel?

    Learn more about the capital to risk-weighted assets ratio and how to calculate a bank's capital adequacy ratio using Microsoft ... Read Answer >>
  4. Why is the capital adequacy ratio important to shareholders?

    Understand what the capital adequacy ratio is and why it is a very important metric of financial soundness for evaluating ... Read Answer >>
  5. What is the Federal Reserve Board's market risk capital rule?

    Learn about the market risk capital rule enacted by the Federal Reserve, and understand how this it reflects Basel III international ... Read Answer >>
  6. How can an investor determine the efficiency of a company's working capital management?

    Learn how working capital is vital to a company’s survival and key metrics investors use to assess how efficiently a company ... Read Answer >>
Related Articles
  1. Personal Finance

    Is Your Bank On Its Way Down?

    Find out how the Tier 1 capital ratio can be used to tell if your bank is going under.
  2. Investing

    Understanding The Basel III International Regulations

    The Basel III regulations mark a drastic reform in international banking. But how do they impact the future's investment landscape?
  3. Personal Finance

    How Basel 1 Affected Banks

    The 1988 Basel 1 agreement sought to decrease bankruptcies among major international banks.
  4. Small Business

    Understanding the Capital Adequacy Ratio

    The capital adequacy ratio (CAR) is an international standard that measures a bank’s risk of insolvency from excessive losses. Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable ...
  5. Investing

    Using Economic Capital To Determine Risk

    Discover how banks and financial institutions use economic capital to enhance risk management.
  6. Investing

    Useful metrics for evaluating bank stocks

    Learn which metrics are most useful to evaluate companies in the banking sector and the issues when comparing them across the various banks.
  7. Insights

    Banks Could Unlock Over $200 Billion for Investors

    Passage of a recently introduced Republican bill could free up $200 billion in bank capital.
  8. Managing Wealth

    An Investor's Guide To Bank Stress-Testing

    Just how are bank stress tests performed and what is the logic behind them? And is a stress test useful for evaluating a bank's stock?
RELATED TERMS
  1. Basel III

    Basel III is a comprehensive set of reform measures designed ...
  2. Basel Accord

    The Basel Accord is a set of agreements on banking regulations, ...
  3. Tier 3 Capital

    Tier 3 capital is tertiary capital, which many banks hold in ...
  4. Tier 1 Leverage Ratio

    The Tier 1 leverage ratio is the relationship between a banking ...
  5. Basel I

    Basel I is a set of bank regulations laid out by the BCBS which ...
  6. McDonough Ratio

    The McDonough ratio is a bank capital adequacy measure coming ...
Trading Center