Capital Adequacy and the Basel Framework

Banks fund most of their lending with deposits and borrowings, and only a small share with shareholders’ money. That shareholders’ money — capital — is what absorbs losses before depositors are affected. Capital adequacy rules require banks to hold enough capital relative to the risks they take. The international standard for those rules is the Basel framework, developed by the Basel Committee on Banking Supervision (BCBS) at the Bank for International Settlements and implemented by national regulators.

Why capital matters

Consider a bank with assets of 1,000 funded by 920 of deposits and borrowings and 80 of equity. If loans worth 50 turn out to be uncollectable, equity falls to 30 and the bank is still solvent. If losses reach 90, equity is wiped out and depositors face losses. Capital is the buffer between bad loans and depositors’ money. Higher capital also gives shareholders more to lose, which encourages prudent behaviour.

What counts as capital

Basel III defines regulatory capital in tiers according to its ability to absorb losses:

Tier	Main components	Role
Common Equity Tier 1 (CET1)	Ordinary shares, share premium, retained earnings, other reserves, less regulatory deductions such as goodwill and certain deferred tax assets	Highest quality; absorbs losses while the bank is a going concern
Additional Tier 1 (AT1)	Perpetual instruments that can be written down or converted into equity	Going-concern loss absorption
Tier 2	Subordinated debt with a minimum maturity, and certain general provisions within limits	Absorbs losses if the bank fails (gone concern)

Tier 1 capital = CET1 + AT1. Total capital = Tier 1 + Tier 2.

Risk-weighted assets

Not all assets are equally risky. Cash and claims on a country’s own government in its own currency usually carry low or zero risk weights; unsecured corporate loans carry higher weights. Risk-weighted assets (RWA) apply a weight to each exposure. Under the standardised approach, the weights are set by the regulator, partly based on external credit ratings; under the internal ratings-based (IRB) approach, approved banks use their own estimates of probability of default and loss given default within regulatory formulas. RWA also include capital charges for market risk and operational risk.

Basel III minimum requirements

The Basel III framework, introduced after the 2007–2009 global financial crisis, sets these minimums as a share of RWA:

Requirement	Minimum
CET1	4.5%
Tier 1	6.0%
Total capital	8.0%
Capital conservation buffer (CET1)	2.5%
Countercyclical buffer (CET1, set nationally)	0–2.5%

With the conservation buffer, the effective CET1 requirement becomes 7.0% and total capital 10.5%. A bank that dips into its buffers faces restrictions on dividends and bonuses until it rebuilds them. Globally systemically important banks carry additional surcharges.

National regulators may set stricter requirements than the Basel minimums, and many do. In Bangladesh, Bangladesh Bank implements the Basel framework through its own capital adequacy guidelines; banks should refer to the current guidelines for the applicable ratios.

The leverage ratio

Risk weights can be wrong or gamed. Basel III therefore adds a simple, non-risk-based backstop:

The three pillars

1. Pillar 1 — minimum capital requirements for credit, market and operational risk.
2. Pillar 2 — supervisory review. Banks assess all their risks, including those not fully captured in Pillar 1 (such as concentration and interest rate risk in the banking book), through an internal capital adequacy assessment; supervisors review it and can require more capital.
3. Pillar 3 — market discipline. Banks publish detailed disclosures on capital, risk exposures and risk management so that investors and depositors can judge their soundness.

Basel III also introduced liquidity standards — the liquidity coverage ratio and the net stable funding ratio — explained in the liquidity risk guide.

Limitations of capital rules

• Model risk: internal models can underestimate risk. The 2017 finalisation of Basel III (sometimes called "Basel IV") introduced an output floor limiting how far internal-model RWA can fall below the standardised approach.
• Procyclicality: losses in a downturn reduce capital just as lending is most needed; buffers are designed to ease this.
• Accounting quality: capital ratios are only as reliable as the loan classification and provisioning behind them — weak recognition of non-performing loans overstates capital.
• Complexity: detailed rules impose costs, especially on smaller banks.

Common mistakes

• Confusing total assets with risk-weighted assets.
• Treating all capital as equal; CET1 is far more loss-absorbing than Tier 2.
• Reading a high capital ratio as proof of safety without checking asset quality and liquidity.
• Assuming national rules match the Basel minimums exactly.