Overview of Financial Risks and Regulatory Frameworks › Key Parameters
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The key parameters for the Basel RWA calculation each capture regulatory judgments about relative riskiness:
- Exposure: The nominal value of the asset on the balance sheet. This represents the maximum amount the bank could lose if the asset became worthless.
- Risk Weight: A percentage factor assigned by regulators reflecting the asset's credit risk (e.g., 0% for cash, 100% for standard corporate loans). Risk weights are set based on historical loss experience, regulatory judgment, and policy objectives. Higher risk weights effectively increase the cost of holding certain assets by requiring more capital backing.
- RWA: Risk-Weighted Assets, calculated as Exposure × Risk Weight. This is the key metric for capital adequacy: banks must hold capital equal to a minimum percentage of their RWA.
Capital Requirements Under Basel III
Basel III substantially strengthened capital requirements in both quantity and quality:
Minimum capital ratios:
| Capital Type | Minimum Requirement |
|---|---|
| Common Equity Tier 1 (CET1) | 4.5% of RWA |
| Tier 1 Capital | 6.0% of RWA |
| Total Capital | 8.0% of RWA |
| Capital Conservation Buffer | 2.5% of RWA |
| Total with Buffer | 10.5% of RWA |
Additional requirements:
- Countercyclical buffer: 0-2.5% additional CET1, set by national regulators based on credit conditions
- Systemic risk buffer: Additional requirements for globally systemically important banks (G-SIBs)
- Leverage ratio: Minimum 3% Tier 1 capital to total exposure (not risk-weighted)
Liquidity Requirements
Basel III introduced two key liquidity metrics designed to ensure banks can survive short-term stress and maintain stable funding over longer horizons:
-
Liquidity Coverage Ratio (LCR): Banks must hold high-quality liquid assets (HQLA) sufficient to cover 30 days of net cash outflows under a stress scenario. The minimum LCR is 100%. This requirement ensures that banks can survive a month-long liquidity crisis without requiring central bank intervention.
-
Net Stable Funding Ratio (NSFR): Banks must maintain stable funding (capital and long-term liabilities) sufficient to cover illiquid assets and potential contingent claims over a one-year horizon. The minimum NSFR is 100%. This requirement addresses maturity mismatch, discouraging banks from funding long-term illiquid assets with short-term volatile funding.
We can calculate the Liquidity Coverage Ratio (LCR) for a bank using the following components. The LCR is defined as the ratio of high-quality liquid assets to net cash outflows over a 30-day stress period:
# Example LCR calculation
hqla = {
"Central Bank Reserves": 80,
"Government Securities": 120,
"High-Grade Corporate Bonds (85% haircut)": 50 * 0.85,
}
outflows = {
"Retail Deposits (5% run-off)": 500 * 0.05,
"Wholesale Deposits (25% run-off)": 300 * 0.25,
"Committed Credit Lines (10% draw)": 200 * 0.10,
}
inflows = {"Maturing Loans (50% cap on inflows)": 60 * 0.50}
total_hqla = sum(hqla.values())
total_outflows = sum(outflows.values())
total_inflows = sum(inflows.values())
net_outflows = max(
total_outflows - total_inflows, total_outflows * 0.25
) # Floor at 25% of outflows
lcr = total_hqla / net_outflows * 100
compliance_status = "COMPLIANT" if lcr >= 100 else "NON-COMPLIANT"Liquidity Coverage Ratio (LCR) Calculation ============================================================ High-Quality Liquid Assets (HQLA): Central Bank Reserves: $80.0M Government Securities: $120.0M High-Grade Corporate Bonds (85% haircut): $42.5M Total HQLA: $242.5M 30-Day Outflows: Retail Deposits (5% run-off): $25.0M Wholesale Deposits (25% run-off): $75.0M Committed Credit Lines (10% draw): $20.0M Total Outflows: $120.0M 30-Day Inflows: Maturing Loans (50% cap on inflows): $30.0M Total Inflows: $30.0M Net Cash Outflows: $90.0M Liquidity Coverage Ratio: 269.4% Minimum Required: 100% Status: COMPLIANT
The LCR calculation results in a ratio well above the 100% threshold, indicating that the bank's high-quality liquid assets are sufficient to cover the projected net cash outflows under stress. The various run-off rates (5% for retail deposits, 25% for wholesale deposits) reflect regulatory assumptions about how quickly different funding sources might flee during a crisis. Retail deposits are considered more stable because they are typically insured and held by less sophisticated depositors, while wholesale deposits are considered more flight-prone.