Bank capital is the loss-absorbing funding of a bank, consisting principally of shareholders’ equity and, for regulatory purposes, certain qualifying financial instruments. It provides a cushion against losses and helps protect depositors and other creditors. Capital is not a separate stockpile of cash: it finances assets alongside deposits and borrowing. Its accounting definition differs from the regulatory measures used to assess whether a bank can withstand financial stress. (bankofengland.co.uk)
Accounting meaning and loss absorption
A bank’s balance sheet records assets, liabilities, and equity. Assets include loans, securities, and cash; liabilities include customer deposits and borrowing. Shareholders’ equity is the residual:
Equity = Assets − Liabilities
Equity includes shareholders’ contributions, retained earnings, and other accounting components. When a bank recognizes losses, these generally reduce earnings and equity. Shareholders therefore absorb losses before depositors and other creditors, although the treatment of individual claims depends on their contractual and legal priority. (bankofengland.co.uk)
For illustration, a simplified bank with assets of $100 million and liabilities of $92 million has $8 million of equity. If recognized asset losses total $3 million while liabilities remain unchanged, equity falls to $5 million. This example demonstrates the accounting mechanism, not a regulatory capital calculation.
Capital is distinct from bank reserves, which are assets such as balances held at a central bank. It also differs from liquidity, the capacity to meet payments when due. A bank with positive equity may nevertheless struggle to obtain cash during a bank run. Conversely, access to cash does not by itself repair an underlying deficiency of assets relative to liabilities. (bankofengland.co.uk)
Regulatory capital
Regulatory capital comprises instruments and accounting items that meet specified loss-absorption criteria, after regulatory adjustments. It is therefore not identical to reported equity. The Basel framework divides it into three principal components:
- Common Equity Tier 1 (CET1): predominantly qualifying common shares, retained earnings, and disclosed reserves, after adjustments. It is the highest-quality regulatory capital.
- Additional Tier 1 (AT1): qualifying subordinated instruments with no maturity date, discretionary distributions, and prescribed loss-absorption features.
- Tier 2 capital: qualifying instruments, including certain subordinated debt, intended principally to absorb losses when a bank becomes non-viable or is wound up. Eligible instruments generally have an original maturity of at least five years.
CET1 plus AT1 constitutes Tier 1 capital; Tier 1 plus Tier 2 constitutes total regulatory capital. (bis.org)
Some bonds can qualify as capital despite being classified as liabilities in financial statements. Ordinary deposits and ordinary senior debt do not qualify merely because they fund the bank. Regulatory deductions, including deductions for goodwill and certain other assets, help exclude items whose loss-absorbing value is insufficient for prudential purposes. (bis.org)
Capital ratios and risk measurement
A capital adequacy ratio compares eligible capital with risk-weighted assets (RWA). Risk weights and other calculation methods translate exposures into a regulatory measure of risk. RWA incorporate credit risk, market risk, and operational risk; they are not simply the bank’s total accounting assets. (bis.org)
The basic calculation is:
Risk-based capital ratio = Eligible capital ÷ RWA × 100%
Under the Basel framework, minimum risk-based ratios are 4.5% for CET1, 6% for Tier 1, and 8% for total capital. These are baseline international standards, not a complete statement of every bank’s applicable requirements. Buffers, supervisory additions, and national rules can raise the effective requirement. (bis.org)
A separate leverage ratio provides a non-risk-based backstop. The Basel measure divides Tier 1 capital by an exposure measure covering on-balance-sheet assets and specified off-balance-sheet exposures, with particular treatments for derivatives and securities financing. Its baseline minimum is 3%; additional requirements apply to global systemically important banks. The exposure measure is not identical to accounting assets. (bis.org)
Buffers and international standards
The Basel Accords established a common international approach to capital adequacy. Basel I was issued in July 1988; Basel II followed in 2004. Reforms developed after the global financial crisis strengthened capital quality, introduced additional buffers, and added a leverage backstop. The standards require implementation through national regulatory arrangements, so their application differs across jurisdictions. (bis.org)
The Basel capital conservation buffer requires an additional 2.5% of RWA in CET1 above minimum requirements. Falling into this buffer generally restricts distributions, including dividends and share repurchases, rather than automatically requiring the bank to cease operating. (bis.org)
A countercyclical capital buffer is a tool of macroprudential policy. Authorities can increase it when credit conditions indicate rising system-wide risk and release it during stress. Systemically important banks also face additional requirements reflecting the consequences their distress could have for the financial system. (bis.org)
Capital management and stress testing
Banks can strengthen capital by retaining profits or issuing qualifying instruments. Dividends, share repurchases, and losses can reduce it. Capital ratios also change when exposures grow, shrink, or become more heavily risk-weighted; an improving ratio therefore does not necessarily mean that the amount of capital has increased. (bankofengland.co.uk)
Bank stress testing examines how hypothetical adverse conditions would affect losses, revenue, expenses, and capital. Supervisors use these exercises to assess resilience and capital planning; the scenarios are not forecasts. In the United States, the Federal Reserve also uses supervisory stress-test results in setting capital requirements for large banks. (federalreserve.gov)