Bank capital and the Basel framework

Capital is the part of a bank’s funding that can absorb losses without the bank defaulting on depositors. It mostly comes from shareholders. Regulators set capital requirements so that a bank can suffer losses and keep operating, or fail without loss to depositors and taxpayers.

The international standard is the Basel framework, set by the Basel Committee on Banking Supervision at the Bank for International Settlements. Basel standards are not law in themselves. Each jurisdiction transposes them, sometimes with stricter settings, and applies them to its banks.

The three layers of capital

Basel III divides regulatory capital into tiers according to how reliably each instrument absorbs losses. The Financial Stability Institute and the Basel III text describe them as follows.

Tier	Main components	Role
Common Equity Tier 1 (CET1)	Ordinary shares, share premium, retained earnings, other reserves, after regulatory deductions	Highest quality. Absorbs losses immediately while the bank is a going concern
Additional Tier 1 (AT1)	Perpetual subordinated instruments with fully discretionary coupons, written down or converted at a trigger	Going-concern loss absorption
Tier 2	Subordinated debt with an original maturity of at least five years	Gone-concern capital. Absorbs losses in resolution or liquidation, ahead of depositors

Tier 1 capital is CET1 plus AT1. Total capital is Tier 1 plus Tier 2.

Regulatory deductions matter more than many applicants expect. Under Basel III, goodwill and other intangibles and deferred tax assets that rely on future profitability are deducted from CET1.

The EU CRR exempts prudently valued software assets from the intangibles deduction under conditions, so the treatment of a capitalised technology build must be checked jurisdiction by jurisdiction. Start-up losses also create tax losses carried forward, which can produce deductible deferred tax assets.

Risk-weighted assets

Capital ratios are expressed as a percentage of risk-weighted assets (RWAs), not total assets. Each exposure is multiplied by a risk weight that reflects its credit risk, and amounts for market risk and operational risk are added.

Banks can use standardised approaches set by the regulator, or, with approval, internal models. New banks almost always start on standardised approaches.

Under Article 92 of the EU Capital Requirements Regulation, each ratio is the relevant capital “expressed as a percentage of the total risk exposure amount”. Capital requirements for market and operational risk are converted into risk exposure amounts by multiplying them by 12.5, which is the reciprocal of 8%.

The output floor

The 2017 finalisation of Basel III limits the benefit of internal models. A bank’s RWAs must be the higher of its modelled RWAs and 72.5% of the RWAs calculated using only standardised approaches, according to the Basel Committee’s high-level summary. The BIS describes transitional arrangements running from 2017 to 2028.

The EU transposed the floor into Article 92(3) of the CRR with the same 72.5% factor and its own transitional rules. The floor mainly affects large banks with internal models.

Basel III minimum ratios and buffers

The Basel III calibration table sets the minimums and the conservation buffer.

Requirement	CET1	Tier 1	Total capital
Minimum	4.5%	6.0%	8.0%
Capital conservation buffer	2.5%
Minimum plus conservation buffer	7.0%	8.5%	10.5%
Countercyclical buffer range	0% to 2.5%

The EU applies the minimums through CRR Article 92 and the conservation buffer through CRD Article 129, which requires a buffer of CET1 “equal to 2,5 % of their total risk exposure amount”.

How buffers work

Buffers are not minimums in the same sense. A bank can use them in stress, but there is a price. According to the FSI summary, whenever the conservation buffer falls below 2.5%, automatic constraints apply to distributions such as dividends, share buybacks and discretionary bonuses.

The countercyclical buffer varies between 0% and 2.5% of RWAs and must be met with CET1. National authorities raise it when they judge aggregate credit growth to be excessive. The FSI notes that increases are pre-announced up to 12 months in advance, while decreases can take effect immediately.

Systemically important banks carry further buffers. Global systemically important banks hold a surcharge set by their systemic score, and national authorities set buffers for domestically important banks. In the EU, a further systemic risk buffer can apply under CRD Article 133.

Pillar 2

Supervisors add bank-specific requirements for risks that the minimums do not capture, such as interest rate risk in the banking book or concentration risk. In the EU this additional own funds requirement is set under CRD Article 104a and sits between the minimums and the buffers. Supervisors can also communicate guidance on additional own funds under Article 104b, which sits on top.

For a new bank, the total requirement is therefore a stack: minimum, Pillar 2 requirement, combined buffer, and any guidance. Business plans that target only 8% total capital will not be accepted.

The leverage ratio

The leverage ratio is Tier 1 capital divided by an exposure measure that broadly follows accounting values, with specific treatment for derivatives, securities financing and off-balance-sheet items. It ignores risk weights on purpose. It is a backstop against errors in risk weighting and against excessive balance sheet growth in assets with low risk weights.

The Basel Committee tested a minimum of 3%, and the EU applies a leverage ratio of 3% under CRR Article 92(1)(d).

Global systemically important banks also hold a leverage ratio buffer. Under the finalised Basel III reforms, it is set at 50% of the bank’s risk-based G-SIB buffer and must be met with Tier 1 capital. The EU applies the same 50% factor in CRR Article 92(1a).

For banks that hold mostly low-risk-weight assets, such as mortgage lenders or banks investing deposits in government bonds, the leverage ratio can bind before the risk-based ratios do.

Minimum initial capital for a licence

Ongoing capital ratios differ from the minimum initial capital needed to obtain a licence. Initial capital is an absolute amount that an applicant must hold at authorisation.

Jurisdiction	Minimum initial capital	Source
European Union	At least EUR 5 million; Member States may authorise particular categories with no less than EUR 1 million after notifying the Commission and EBA	CRD Article 12
Dubai International Financial Centre (DFSA)	Base capital requirement of US$10 million for Category 1 firms, which are those authorised to accept deposits; US$2 million for Category 2 firms that provide credit without taking deposits	DFSA Rulebook, PIB 1.3 and 3.6
Abu Dhabi Global Market (FSRA)	Base capital requirement of US$10 million for Category 1 (accepting deposits); US$2 million for Category 2	FSRA Rulebook, PRU 1.3 and 3.3

These are base amounts, not the full requirement. Under DFSA PIB 3.3.2, for example, a Category 1 firm’s capital requirement is the higher of the base capital requirement and its risk capital requirement plus applicable buffers.

Other jurisdictions set their own absolute minimums in national banking laws, and some set different figures for full, restricted or digital licence classes. Applicants should take the current figure from the regulator’s own legislation or licensing guidance at the time of application, because these amounts are revised.

Why the legal minimum is rarely the real number

Supervisors size capital from the business plan, not from the statutory floor. The ECB’s guide to fintech bank licence applications states that the ECB and national authorities will assess whether the applicant can “hold in reserve sufficient capital to cover start-up losses in the first three years of activity” and, where applicable, the costs of executing an exit plan.

The same guide gives examples where capital above the minimum could be warranted, such as a new bank entering a developed market with an aggressive pricing strategy. In practice, the capital an applicant must commit equals:

1. Capital to meet ratio requirements on the projected balance sheet, including buffers and Pillar 2.
2. Plus cumulative start-up losses until break-even, under a stressed as well as a base case.
3. Plus a management buffer above all requirements, so that normal volatility does not trigger distribution limits.
4. Plus, where required, the cost of an orderly wind-down.

Questions supervisors ask about capital

1. Is the capital genuinely paid up, and is its source documented and legitimate?
2. Does any part of it depend on debt raised by the shareholders, which could create pressure for dividends?
3. Can the shareholders provide more capital if the plan underperforms, and is that commitment credible?
4. Which deductions apply to the planned balance sheet, especially intangible assets and deferred tax assets?
5. At what point in the stressed case does the bank breach its buffers, and what will management do then?

The next article covers the second pillar of prudential soundness: liquidity and stable funding.