Capital Adequacy and Basel Accords
What this domain tests
This domain tests how regulatory capital is defined, measured against risk-weighted assets, and constrained by buffers and leverage. Questions often require distinguishing minimums from buffers, CET1 from total capital, standardized from internal-ratings-based approaches, and Pillar 1 from Pillar 2 and Pillar 3.
Core rules and concepts
Basel III sets minimum CET1 at 4.5% of RWA, Tier 1 at 6%, and total capital at 8%. The capital conservation buffer of 2.5% sits above the minimums, and a countercyclical buffer of up to 2.5% may apply. G-SIBs face surcharges. Breaching the combined buffer restricts distributions through maximum distributable amount mechanics.
RWA includes credit risk, market risk, and operational risk. The standardized approach uses supervisory risk weights; internal models may reduce RWA but are subject to approval, model risk controls, and an output floor. The leverage ratio is Tier 1 capital divided by exposure measure, generally with a 3% minimum; enhanced supplementary leverage standards apply to large U.S. banking organizations. Pillar 2 addresses risks not fully captured in Pillar 1, and Pillar 3 requires public disclosures.
Worked example
A bank has CET1 capital of USD 6 million, Tier 1 capital of USD 7 million, total capital of USD 9 million, RWA of USD 100 million, and an exposure measure of USD 140 million. CET1 is 6.0%, Tier 1 is 7.0%, and total capital is 9.0%. All three exceed the 4.5%, 6%, and 8% minimums. With a 2.5% conservation buffer, the CET1 requirement is 7.0%, so the bank is above the minimum but inside the buffer and faces distribution restrictions. The leverage ratio is 7/140 = 5.0%, above 3%.
Traps that cost marks
- Comparing CET1 with the 8% total capital minimum.
- Adding the conservation buffer to the 8% total capital minimum instead of applying it to CET1.
- Using RWA as the leverage denominator; the exposure measure is broader.
- Treating internal-model RWA as free of supervisory constraints.
- Forgetting that operational risk consumes capital even in a lending-focused bank.