Bank Capital Adequacy

Bank capital adequacy is the question of whether a bank holds enough capital, meaning shareholders' funds and other loss-absorbing resources, to absorb losses on its loans and investments and still keep operating. Supervisors judge it mainly through capital ratios that compare a bank's regulatory capital with its risk-weighted assets, under standards set by the Basel Committee on Banking Supervision.

Capital adequacy is different from liquidity. A bank can be well capitalised but short of cash, or flush with cash but too thin on capital to survive large losses, which is why rules on capital sit alongside separate liquidity rules. National supervisors such as the US federal banking agencies, the European Central Bank and the UK's Prudential Regulation Authority apply the Basel standards through their own laws.

Imagine lending money to a friend who runs a market stall. You would feel safer if the friend had put a good amount of their own savings into the business, because if a few weeks go badly, their savings take the hit before your loan does. The more risky the stall's stock, the more of their own money you would want to see.

Capital adequacy applies that logic to banks. A bank's own money is the cushion that protects depositors and other lenders. Regulators decide how thick the cushion must be, and they ask for a thicker one when the bank's assets are riskier.

The broadest measure, the total capital ratio, is often called the capital adequacy ratio (CAR):

• $\text{Tier 1 capital}$ is going-concern capital, mainly common shares and retained earnings, known as Common Equity Tier 1 (CET1), plus Additional Tier 1 instruments.
• $\text{Tier 2 capital}$ is gone-concern capital, mainly long-dated subordinated debt that absorbs losses in a failure.
• $\text{Risk-weighted assets}$ are the bank's exposures, each multiplied by a weight reflecting credit, market and operational risk.

Suppose a bank has CET1 of 70 million, Additional Tier 1 of 15 million, Tier 2 of 20 million and risk-weighted assets of 900 million. Its CET1 ratio is 70 ÷ 900 = 7.8 per cent, its Tier 1 ratio is 85 ÷ 900 = 9.4 per cent, and its total capital ratio is 105 ÷ 900 = 11.7 per cent. The individual instruments are described under regulatory capital instrument.

Under Basel III, banks must hold at least 4.5 per cent CET1, 6 per cent Tier 1 and 8 per cent total capital against risk-weighted assets. On top of these minimums sit buffers that can be drawn down in stress, at the cost of limits on dividends and bonuses:

• Capital conservation buffer. An extra 2.5 per cent of CET1, explained under capital conservation buffer, bringing the effective CET1 floor to 7 per cent.
• Countercyclical buffer. A variable add-on, set by national authorities, that rises when credit is growing fast; see countercyclical capital buffer.
• Systemic surcharges. Additional CET1 for global systemically important banks, scaled to their size and complexity.
• Supervisory add-ons. Bank-specific requirements from supervisory review, such as Pillar 2 in Europe and the stress capital buffer in the United States.

Basel III also introduced a non-risk-based leverage ratio with a 3 per cent minimum of Tier 1 capital to total exposures, as a backstop to risk weights.

The first international standard, the Basel Capital Accord of 1988, set the 8 per cent minimum and simple risk weights for broad classes of assets. Basel II, agreed in 2004, allowed large banks to use internal models for risk weights and added supervisory review and disclosure. The 2007 to 2009 financial crisis showed that many banks had too little high-quality capital, which led to Basel III in 2010, with stricter definitions of capital and the new buffers. A final package agreed in 2017 limited the benefit of internal models through an output floor. Implementation of that last package has been phased in at different speeds, with several jurisdictions delaying parts of it.

Capital ratios are only as good as the risk weights behind them. Assets judged safe, such as government bonds, can carry low or zero weights and still lose value, as rising interest rates showed in 2022 and 2023. Internal models allowed banks to report very different ratios for similar portfolios, and some economists argue that minimums remain too low compared with the equity levels of non-financial companies. Others warn that higher capital requirements raise the cost of lending. Capital adequacy also says little about liquidity risk, and bank failures often come from runs before losses wipe out capital. Resolution tools such as bail-in were added so that losses beyond capital fall on investors rather than taxpayers.

• Basel Committee on Banking Supervision