# Capital Adequacy and Basel Ratios: How Much Loss Can a Bank Absorb
A bank holds $100 in mortgages and $100 in corporate loans. Under Basel III, the mortgages force it to set aside far less capital than the corporate loans, even though both are worth the same on paper. That single rule shapes what banks lend, to whom, and at what price. Let us see exactly how.
When regulators talk about capital, they do not mean cash in the vault. They mean the loss-absorbing cushion between a bank's assets and its obligations to depositors and bondholders.
The purest form is CET1 (Common Equity Tier 1): common shares plus retained earnings, minus some deductions. It is the first money to disappear when loans go bad. If a bank loses $5 on defaulted loans, that $5 comes out of CET1 before any depositor is touched.
More CET1 means a bank can eat more losses before failing. That is the whole game.
A bank does not hold capital against its total assets. It holds capital against risk-weighted assets (RWA): each asset scaled by how risky regulators judge it to be.
The formula for a single asset:
RWA = Exposure × Risk WeightRisk weights under the Basel standardised approach (the simpler of two methods) roughly follow credit risk:
So a $100 mortgage at a 50% risk weight becomes $50 of RWA. A $100 corporate loan at 100% becomes $100 of RWA. The corporate loan consumes twice the risk budget even though the balance sheet shows the same $100.
The headline metric regulators watch:
CET1 ratio = CET1 capital / Risk-weighted assetsLet us build a tiny bank.
Assets:
Capital:
CET1 ratio = 12 / 150 = 8.0%
That 8.0% means the bank holds $8 of pure equity for every $100 of risk-weighted exposure.
Suppose the bank shifts $100 from corporate lending into mortgages. Same total assets ($200), same $12 of capital.
CET1 ratio = 12 / 100 = 12.0%
Nothing about the bank's size changed. By tilting toward lower-risk-weight assets, the same capital now covers a much healthier ratio. This is why capital rules quietly steer banks toward mortgages and away from unrated corporate credit.
Basel III sets a stack of requirements, not one number. As a rough guide:
Our first bank at 8.0% clears the 7.0% conservation-buffer level, but only just. A wave of corporate defaults could push it below, triggering restrictions on dividends and bonuses.
The Basel framework itself is published by the Bank for International Settlements. You can browse the consolidated standards at the BIS Basel Framework.
Large banks may use the IRB (Internal Ratings-Based) approach, estimating their own default probabilities to set risk weights, subject to regulator approval. Smaller banks use the standardised weights above.
The concern: two banks holding identical portfolios could report different RWA, because one uses aggressive internal models. To curb this, Basel III introduced an output floor. A bank's model-based RWA cannot fall below 72.5% of what the standardised approach would produce. Model gains are capped.
These final Basel III reforms (often called Basel III Endgame in the US and Basel 3.1 in the UK and EU) are phasing in through the mid-2020s and into 2026, with transitional arrangements varying by jurisdiction.
🎬 [VIDEO: "Basel III in 10 minutes" — youtube.com — a concise walkthrough of the capital, leverage, and liquidity pillars]
Risk weights can be gamed. So Basel added a leverage ratio that ignores them entirely:
Leverage ratio = Tier 1 capital / Total exposure (unweighted)The minimum is generally 3%, with a surcharge for the biggest banks. This catches a bank that has stuffed itself with "low risk weight" assets that turn out to be dangerous. The 2008 crisis featured banks with respectable risk-weighted ratios but wafer-thin unweighted equity. The leverage ratio is the crude, honest check on that trick.
Capital is not free. Shareholders demand a return on it. So every loan carries an implicit capital cost.
Consider our two $100 loans again. The corporate loan requires capital against $100 of RWA; the mortgage against only $50. To hit the same return on equity, the bank must charge the corporate borrower a wider margin, or decline the loan.
This is why:
The risk weight is not an accounting footnote. It is a price signal baked into the rulebook.
Vérification des acquis
1. Why does a $100 corporate loan consume more of a bank's capital budget than a $100 residential mortgage under the Basel standardised approach?
2. In the regulatory sense used here, what does a bank's 'capital' primarily represent?
3. A bank suffers $5 of losses on defaulted loans. Why is CET1 described as the 'first money to disappear'?
4. Select ALL correct answers about how risk weights work under the Basel standardised approach.
Sélectionnez toutes les réponses correctes.
5. Select ALL correct answers about the CET1 ratio and its components.
Sélectionnez toutes les réponses correctes.
Ratios measure today. Regulators also ask: what about a severe recession?
Stress tests project a bank's capital under a hypothetical shock (say, unemployment spiking and house prices falling). The US Federal Reserve runs an annual exercise; the European Banking Authority and the Bank of England run their own. A bank might show a comfortable 12% CET1 ratio today but fall toward the minimum in a modelled crisis.
The key insight: a static ratio can look strong while hiding concentration risk. A bank heavy in one region's mortgages could see that "safe" 50% risk-weight book generate large losses at once. Stress tests expose what point-in-time RWA cannot.
You can read how the Federal Reserve frames its exercise on its stress tests page.
Two banks, each with $12 of CET1:
| | Bank A (corporate-heavy) | Bank B (mortgage-heavy) |
|---|---|---|
| Corporate loans | $150 (RW 100%) | $50 (RW 100%) |
| Mortgages | $50 (RW 50%) | $150 (RW 50%) |
| RWA | $150 + $25 = $175 | $50 + $75 = $125 |
| CET1 ratio | 12 / 175 = 6.9% | 12 / 125 = 9.6% |
Same capital. Same $200 balance sheet. Bank A sits below the 7.0% buffer threshold and would face dividend restrictions. Bank B has room to grow. The only difference is the risk profile of what they chose to lend.