Pillar 1 Capital Requirement

The Pillar 1 capital requirement is the minimum amount of capital that the Basel framework requires of every bank, calculated according to common rules. It covers three categories of risk, namely credit risk, market risk and operational risk, and it is expressed as a ratio of the bank's capital to its risk-weighted assets. Because the same formulas apply to all banks, Pillar 1 is the part of the capital regime that can be compared directly from one institution to another.

The name comes from the three-pillar structure introduced by Basel II in 2004. Pillar 1 sets minimum requirements; the Pillar 2 capital requirement adds bank-specific amounts through supervisory review; and Pillar 3 disclosure exposes the results to market scrutiny. The structure was kept under Basel III, which raised the quantity and quality of capital required.

Under Basel III a bank must at all times hold capital equal to at least the following percentages of risk-weighted assets:

• Common Equity Tier 1: 4.5 per cent. Common Equity Tier 1 is the highest-quality capital, made up of ordinary shares and retained earnings less deductions.
• Tier 1: 6 per cent. This may include up to 1.5 percentage points of Additional Tier 1 capital.
• Total capital: 8 per cent. This may include up to 2 percentage points of Tier 2 capital.

The 8 per cent total dates from the first Basel Accord of 1988. What Basel III changed was the composition: before the reform, common equity could be as little as 2 per cent of risk-weighted assets, and the definition of capital allowed items that proved unable to absorb losses.

The denominator of the ratio is the sum of three components. For credit risk, each exposure is multiplied by a risk weight reflecting the likelihood and severity of loss. Banks use either the standardised approach for credit risk, in which the regulator prescribes the weights, or, with supervisory permission, the internal ratings-based approach, in which the bank's own estimates of default probability and loss feed a regulatory formula.

For the other two risks the rules produce a capital figure directly, which is multiplied by 12.5, the reciprocal of 8 per cent, to convert it into an equivalent amount of risk-weighted assets. The methods are described under market risk capital and operational risk capital. Further charges cover counterparty credit risk on derivatives, credit valuation adjustment risk and securitisation positions.

As a simple illustration, a bank with risk-weighted assets of 500 million for credit risk, 20 million for market risk and 60 million for operational risk has a total of 580 million. Its Pillar 1 minimum is 46.4 million of total capital, of which at least 26.1 million must be Common Equity Tier 1.

Banks using internal models reported widely differing risk weights for similar portfolios, which undermined confidence in the ratios. The final Basel III reforms, agreed in December 2017, responded by restricting the use of models for some exposure classes, setting minimum values for model inputs, and introducing an output floor: a bank's total risk-weighted assets may not be lower than 72.5 per cent of the amount calculated using only standardised approaches. Jurisdictions are phasing the floor in over several years on their own timetables.

Pillar 1 also includes a requirement that does not depend on risk weights. The leverage ratio requires Tier 1 capital of at least 3 per cent of total exposure, including off-balance-sheet items, and serves as a backstop where risk weights are very low.

The Pillar 1 minimum is only the base of a bank's capital stack. Above it sit the Pillar 2 requirement and then the combined buffer, which includes the capital conservation buffer, the countercyclical capital buffer and surcharges for systemically important banks. Breaching a buffer restricts dividends and bonuses; breaching the Pillar 1 minimum is a ground for withdrawing the banking licence or for resolution. Pillar 1 also contains the Basel liquidity standards, although in common usage the phrase refers to the capital minimums.

Pillar 1 is necessarily a simplification. Standard formulas cannot reflect every bank's circumstances, and they leave out risks such as interest rate risk in the banking book and concentration in particular sectors or borrowers, which are dealt with under Pillar 2. Risk weights have at times been badly wrong, most obviously the low weights given to certain mortgage securities and sovereign bonds before the crises of 2008 and 2010 to 2012. The rules have also grown highly complex, which critics argue favours large banks able to optimise against them, and implementation of the final reforms has diverged between major jurisdictions. General background is given under bank capital adequacy.

• Basel Committee on Banking Supervision