Financial Risk Management Regulatory Capital and Basel 1 — Questions and Answers
Question 1: Under Basel III, what is the minimum Common Equity Tier 1 (CET1) capital ratio requirement?
- 2%
- 4.5% (Correct answer)
- 6%
- 8%
Correct answer: 4.5%
Basel III raised the minimum CET1 ratio to 4.5% of risk-weighted assets, with an additional 2.5% capital conservation buffer, making the effective minimum 7% CET1 for most banks.
Question 2: What is the 'capital conservation buffer' under Basel III and what happens when a bank breaches it?
- A 1% CET1 buffer; breaching it triggers immediate regulatory receivership
- A 2.5% CET1 buffer above the 4.5% minimum; breaching it restricts dividend payments and discretionary bonuses (Correct answer)
- A 3% Tier 2 buffer; breaching it requires the bank to issue new equity within 30 days
- A 1.5% Additional Tier 1 buffer; breaching it triggers automatic bail-in of subordinated debt
Correct answer: A 2.5% CET1 buffer above the 4.5% minimum; breaching it restricts dividend payments and discretionary bonuses
The 2.5% conservation buffer acts as a cushion; when a bank dips into it, escalating restrictions on capital distributions (dividends, buybacks, bonuses) are triggered to help rebuild the buffer.
Question 3: What is the 'countercyclical capital buffer' (CCyB) under Basel III?
- A fixed 2.5% buffer held permanently by all systemically important banks
- A variable buffer (0–2.5%) that national regulators increase during credit booms and release during downturns to dampen pro-cyclicality (Correct answer)
- A buffer applied only to trading book market risk capital
- A capital surcharge applied permanently to banks with more than $250 billion in assets
Correct answer: A variable buffer (0–2.5%) that national regulators increase during credit booms and release during downturns to dampen pro-cyclicality
The CCyB is a macroprudential tool: regulators build it up when credit growth is excessive (preventing overheating) and release it during stress to support lending.
Question 4: What is the 'leverage ratio' under Basel III and what problem does it address?
- Tier 1 capital / risk-weighted assets ≥ 6%; addresses credit concentration
- Tier 1 capital / total exposure ≥ 3%; acts as a backstop against excessive leverage regardless of risk-weighting (Correct answer)
- Total capital / total deposits ≥ 10%; addresses liquidity risk
- CET1 capital / off-balance-sheet items ≥ 5%; addresses shadow banking
Correct answer: Tier 1 capital / total exposure ≥ 3%; acts as a backstop against excessive leverage regardless of risk-weighting
The 3% Tier 1 leverage ratio is a non-risk-sensitive backstop that prevents banks from gaming risk-weighted capital ratios by holding low-risk-weighted but highly leveraged exposures.
Question 5: What does 'risk-weighted assets' (RWA) mean in the context of bank capital?
- Total bank assets multiplied by a single 8% capital charge
- Bank assets adjusted by risk weights assigned to different exposure types, so riskier assets require more capital support (Correct answer)
- The market value of assets in the trading book after haircuts
- Total assets minus liabilities, adjusted for off-balance-sheet items
Correct answer: Bank assets adjusted by risk weights assigned to different exposure types, so riskier assets require more capital support
Under Basel, each asset class gets a risk weight (e.g., sovereign bonds = 0%, mortgages = 35–50%, unsecured retail = 75%, unrated corporates = 100%), and capital must be 8% of total RWA.
Question 6: What is a 'G-SIB surcharge' and which institutions are subject to it?
- A 1% capital surcharge applied to all FDIC-insured banks
- An additional CET1 capital buffer of 1–3.5% imposed on Global Systemically Important Banks based on their systemic importance score (Correct answer)
- A leverage surcharge applied to banks with more than $1 trillion in total assets
- A liquidity surcharge requiring G-SIBs to hold 20% more HQLA than standard LCR requirements
Correct answer: An additional CET1 capital buffer of 1–3.5% imposed on Global Systemically Important Banks based on their systemic importance score
G-SIBs are identified annually based on size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity, and must hold additional CET1 capital to reduce the probability of failure of firms that are 'too big to fail.'
Financial Risk Management Regulatory Capital and Basel 1
Under Basel III, what is the minimum Common Equity Tier 1 (CET1) capital ratio requirement?