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Outline the regulatory capital rules set by the Basel committee together with the reasons behind them.

FRM® Part I · Financial Markets and Products · Banks · FRM1.FM.1.c

The idea

Basel I (1988, historical) required capital of at least 8% of risk-weighted assets. The weights were 0% for OECD government debt, 20% for OECD banks, 50% for residential mortgages and 100% for corporate loans. The aim was that banks held adequate capital and competed on a level playing field. Basel II made the rules more risk sensitive through three pillars. They were minimum capital for credit, market and operational risk, supervisory review, and market discipline through disclosure. After the 2007-09 crisis Basel III raised the quality and quantity of capital. It set minimum common equity Tier 1 of 4.5% of risk-weighted assets, Tier 1 of 6% and total capital of 8%, plus a 2.5% capital conservation buffer in common equity and a countercyclical buffer. It also added a leverage ratio of at least 3%, defined as Tier 1 over total exposure with no risk weights. Two liquidity standards were added as well, a 30-day liquidity coverage ratio and a net stable funding ratio, both with a 100% minimum. Exam point: do not mix risk-weighted ratios with the leverage ratio.

Formulas

Basel I minimum capital

Minimum capital = 8% × Σ(wᵢ × Aᵢ)

wᵢ
the risk weight of asset class i: 0%, 20%, 50% or 100%
Aᵢ
the amount held in asset class i

Weight each asset before applying the 8%. Applying 8% to total assets, or giving government debt a non-zero weight, are the usual mistakes.

Basel III leverage ratio

Leverage ratio = Tier 1 ÷ Exposure

Tier 1
Tier 1 capital
Exposure
total leverage exposure, with no risk weights

Must be at least 3%. It is tested separately from the risk-weighted ratios, so do not divide by risk-weighted assets.

Liquidity coverage ratio

LCR = HQLA ÷ NCO

HQLA
the stock of high-quality liquid assets
NCO
net cash outflows over a 30-day stress period

Must be at least 100%. The trap is inverting it, or confusing it with the net stable funding ratio, which compares available with required stable funding.

A practice question

From the question bank, with the reason each wrong option is wrong.

Basel I (1988) required internationally active banks to hold capital equal to at least what proportion of risk-weighted assets?

  1. 8% - correct
  2. 4%Why not: Mistakes the Tier 1 portion for the whole minimum.
  3. 10.5%Why not: Adds the Basel III conservation buffer to the 8%.
  4. 3%Why not: Takes the Basel III leverage ratio floor, which is not risk weighted.

Basel I set a minimum of 8% of risk-weighted assets, intended to give banks adequate capital and a level playing field across countries.

A harder one

A bank holds USD 200 million of OECD government bonds (0% risk weight), USD 100 million of loans to OECD banks (20%), USD 300 million of residential mortgages (50%) and USD 400 million of corporate loans (100%). Under Basel I, its minimum capital is closest to:

  1. USD 80.0 million.Why not: Applies 8% to total assets of 1,000 without risk weights.
  2. USD 48.8 million.Why not: Gives the government bonds a 20% weight instead of 0%.
  3. USD 57.6 million.Why not: Gives the mortgages a 100% weight instead of 50%.
  4. USD 45.6 million. - correct

Risk-weighted assets = 0 + 0.2 x 100 + 0.5 x 300 + 1.0 x 400 = 570 million. Capital = 8% x 570 = 45.6 million.

The hardest tier

A bank has Tier 1 capital of USD 18 billion, risk-weighted assets of USD 200 billion and total leverage exposure of USD 650 billion. Under Basel III, which conclusion is correct?

  1. It is compliant, since Tier 1 is 9% of risk-weighted assets, comfortably above the 6% minimum.Why not: Tests the risk-based ratio only; the leverage ratio uses total exposure and is a separate test.
  2. It fails the leverage ratio and is short by USD 19.5 billion of Tier 1 capital.Why not: Reports the total required capital (3% x 650) as if it were the shortfall.
  3. It fails the 3% leverage ratio (about 2.8%) and needs about USD 1.5 billion more Tier 1. - correct
  4. It fails the leverage ratio and is short by USD 21 billion of Tier 1 capital.Why not: Applies the 6% risk-based Tier 1 ratio to the leverage exposure.

Leverage ratio = 18 / 650 = 2.77%, below 3%. Required Tier 1 = 3% x 650 = 19.5 billion, so the shortfall is 19.5 - 18 = 1.5 billion. The 9% risk-based ratio does not cure this: the leverage ratio is a non-risk-based backstop.

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