Basel capital ratios explained: risk-weighted assets, tiers and buffers
Banks fund themselves with a mix of debt and equity, and capital is the loss-absorbing part. Supervisors do not ask for a flat percentage of total assets alone, because a loan to a weak borrower is riskier than a government bond. The Basel framework, set by the Basel Committee on Banking Supervision, answers with capital ratios measured against risk-weighted assets. It features in FRM® Part II alongside other regulatory topics. For the exam's shape see how the FRM exam is structured, and for other topics see the FRM page.
A caution before starting: the details below are simplified. Risk weights, definitions of capital and minimum ratios vary by jurisdiction and by version of the rules (Basel I, II, III and national implementations), so the numbers here are purely illustrative.
Why risk weights exist
Two banks with the same total assets can carry very different risk. A risk weight scales each exposure by how much capital it should attract, so that safe assets need little and risky assets need more. Risk-weighted assets (RWA) are the sum of exposure x risk weight. Under the standardised approaches, weights typically depend on the type of borrower and collateral. Under internal-model approaches, banks estimate inputs themselves, which links to expected loss, PD, LGD and EAD. RWA also covers market and operational risk, not just credit risk; this guide shows credit-style weights only.
Capital and the ratios
Capital is grouped by quality:
- Common equity tier 1 (CET1): mainly common shares and retained earnings, after regulatory deductions. This is the highest-quality, fully loss-absorbing capital.
- Additional tier 1 (AT1): other instruments that can absorb losses while the bank operates as a going concern.
- Tier 2: lower-quality, gone-concern capital such as certain subordinated debt.
The ratios are:
- CET1 ratio = CET1 / RWA
- Tier 1 ratio = (CET1 + AT1) / RWA
- Total capital ratio = (tier 1 + tier 2) / RWA
Under the Basel framework, minimum ratios are typically set as percentages of risk-weighted assets, and national rules differ. On top of the minimums sit buffers, for example a capital conservation buffer and, for systemically important banks, extra surcharges. Buffers are meant to be run down in stress, and a bank that dips into them usually faces limits on distributions such as dividends. Check the current rules of the relevant jurisdiction for the actual figures.
The leverage ratio idea
Risk weights depend on models and judgement, and they can be gamed or misestimated. The leverage ratio is a simple backstop that ignores risk weights:
Leverage ratio = tier 1 capital / total exposure
It is a non-risk-based measure, intended to limit how much a bank can expand its balance sheet relative to capital, whatever the weights say.
Worked example
An invented lender, Marlowe Ridge Bank, has these assets (millions) and simplified, illustrative risk weights. Numbers were computed and asserted in Python.
| Asset | Amount | Risk weight | RWA |
|---|---|---|---|
| Cash and government bonds | 20 | 0% | 0 |
| Interbank loans | 10 | 20% | 2 |
| Residential mortgages | 40 | 35% | 14 |
| Corporate loans | 25 | 100% | 25 |
| Other assets | 5 | 100% | 5 |
| Total | 100 | 46 |
Suppose the bank holds CET1 of 5.0, AT1 of 1.0 and tier 2 of 1.5.
- CET1 ratio = 5.0 / 46 = 10.87%.
- Tier 1 ratio = 6.0 / 46 = 13.04%.
- Total capital ratio = 7.5 / 46 = 16.30%.
- Leverage ratio = 6.0 / 100 = 6.0%, using balance sheet assets as a stand-in for total exposure.
Now assume, purely for illustration, that this bank's all-in CET1 requirement including buffers is 7% of RWA. The requirement is 0.07 x 46 = 3.22, so headroom is 5.0 - 3.22 = 1.78. If the bank moves 10 from government bonds into corporate loans, total assets stay at 100 but RWA rises to 56 and the CET1 ratio falls to 5.0 / 56 = 8.93%, with no change in capital or in the leverage ratio. This shows why the RWA denominator matters and why the leverage ratio sees nothing.
Usual mistakes
- Dividing capital by total assets when the question asks for a risk-based ratio.
- Mixing tiers: total capital ratio includes tier 2, CET1 ratio includes only CET1.
- Believing a lower risk weight means a safer asset in an absolute sense. Weights are assumptions, and some have been criticised as too low.
- Quoting minimum ratios without saying which rules and which date they come from.
How the exam typically tests it
Typically you compute RWA and the ratios from a small balance sheet, identify which capital counts at each tier, or explain why a leverage ratio complements risk-based ratios. Charta's practice questions for this topic let you rehearse these calculations.
Common questions
What are risk-weighted assets?
They are a bank's exposures scaled by risk weights, so that riskier assets count for more. Capital ratios divide capital by this total.
What is the difference between CET1, tier 1 and total capital?
CET1 is the highest-quality core. Tier 1 adds additional tier 1 instruments. Total capital adds tier 2 on top.
Why have a leverage ratio as well?
It does not depend on risk weights or models, so it acts as a simple check if the weights understate risk.
Are the minimum ratios the same everywhere?
No. They are typically set as percentages of RWA under the Basel framework, but national implementations and versions differ, so check the rules that apply.
Sources
- GARP, the FRM programme: what the exam is and its two parts.
- Basel Committee on Banking Supervision, the committee's website: the Basel standards themselves.
The exam and the syllabus can change. Check GARP's current details before you book.