Capital Requirements Ask How Much of the Loss a Bank Can Absorb
Regulatory capital is not money set aside. It is the portion of assets funded by equity rather than debt, and it determines how far assets can fall before depositors lose.
The Common Misunderstanding
Capital is frequently described as money a bank holds in reserve. It is not held anywhere, and it is not a pool of cash.
Capital describes how assets are funded. A bank with 100 of assets funded by 92 of deposits and borrowing and 8 of equity has 8 percent capital. That 8 is invested in the same loans as everything else.
Capital is not a buffer of cash sitting idle. It is the share of the balance sheet that belongs to shareholders, and therefore the share of losses they absorb before anyone else does.
If assets fall in value by 5, the equity absorbs it and depositors are unaffected. If they fall by 10, equity is exhausted and losses reach creditors.
The Layers of Capital
| Tier | Contains | Loss absorbing quality |
|---|---|---|
| Common equity tier 1 | Ordinary shares, retained earnings | Highest, absorbs first |
| Additional tier 1 | Perpetual instruments, convertible | Absorbs while a going concern |
| Tier 2 | Subordinated debt | Absorbs only in resolution |
Common equity tier 1, abbreviated CET1, is the measure that matters most and the one markets watch. It is the purest form of loss absorption because it has no maturity, no required payment, and ranks last in a failure.
Additional tier 1 instruments convert to equity or are written down if capital falls below a trigger. The Credit Suisse resolution in 2023 demonstrated that these can be written off entirely while shareholders receive something, which was legally permitted under the specific terms and surprised many holders about the ranking they thought they had.
The Denominator Does the Work
Ratios are expressed against risk weighted assets rather than total assets. Each asset receives a weight reflecting its assessed riskiness.
Government bonds of highly rated sovereigns may carry a zero weight, meaning they require no capital. Residential mortgages carry a low weight. Unsecured corporate lending carries a high one.
This is sensible in principle and it is where the system is gamed. A bank can improve its ratio without raising equity by shifting toward lower weighted assets, which improves the reported number while the balance sheet may be no safer in reality.
The zero weight on sovereign debt is the clearest example. It treats government bonds as riskless, which the euro area crisis demonstrated they are not, and it encourages banks to hold their own government debt, which links bank solvency to sovereign solvency.
The Leverage Ratio Backstop
Because risk weights can be manipulated, a simple leverage ratio was introduced alongside them: capital divided by total assets with no risk weighting at all.
It is crude by design. Its function is to place a floor under leverage regardless of how favourably the risk weighted calculation comes out, and it binds for banks holding large volumes of low weighted assets.
Buffers on Top of Minimums
Above the minimum requirement sit several buffers: a capital conservation buffer, a countercyclical buffer that regulators can raise in good times, and surcharges for systemically important institutions.
Operating below the buffers is not failure. It triggers automatic restrictions on dividends, buybacks, and bonuses, which is the mechanism intended to force capital retention before a problem becomes severe.
The practical effect is that banks manage to a level well above the regulatory minimum, because approaching it would restrict distributions and signal weakness.
What It Does Not Cover
Capital addresses solvency, not liquidity. A well capitalised bank can still fail if it cannot meet withdrawals, which is what liquidity rules exist to address separately.
The 2023 regional bank failures were substantially about interest rate risk on securities portfolios and about concentrated uninsured deposits, neither of which the capital ratio captured well.
The Bottom Line
Capital is the share of a bank balance sheet funded by equity, and it measures how much loss can be absorbed before creditors are affected. CET1 against risk weighted assets is the headline, the risk weights are where judgement and gaming live, and the leverage ratio exists as a crude backstop. Capital says nothing about liquidity, which is how well capitalised banks still fail.