Basel III Capital Adequacy Framework

Risk-weighted assets (RWA) measure a bank’s exposures after adjusting them for their relative credit, market and operational risks. Under Basel III, capital adequacy ratios divide eligible regulatory capital by total RWA, so a larger or riskier exposure produces a higher capital requirement.

How RWA are calculated

Banks calculate total RWA by combining prescribed measures for credit risk, market risk and operational risk.

• For credit risk, each on-balance-sheet exposure is multiplied by an applicable risk weight determined under the prescribed approach.
• Off-balance-sheet exposures are first converted into credit-equivalent amounts and then assigned risk weights.
• Market-risk and operational-risk capital charges are converted into equivalent RWA under the applicable methodology.
• Thus, a higher risk weight makes the same rupee exposure generate more RWA and require more capital.

How RWA translate into required capital

The basic relationship is: required capital equals the applicable capital ratio multiplied by total RWA. Common Equity Tier 1 is the highest-quality capital; Tier 1 also includes Additional Tier 1, while total regulatory capital additionally includes Tier 2.

• The Basel III minimum ratios are 4.5% CET1, 6% Tier 1 and 8% total capital, each measured against RWA.
• A 2.5% capital conservation buffer, composed of CET1, normally sits above the minimum requirements.
• Under RBI’s Indian implementation, the corresponding minimums are 5.5% CET1, 7% Tier 1 and 9% total capital, with a 2.5% capital conservation buffer.

Regulatory significance

Risk weighting makes capital requirements sensitive to the riskiness rather than merely the book value of bank assets. A bank can improve its capital ratio by raising eligible capital or reducing its RWA, but Basel III also uses the leverage ratio as a non-risk-based backstop against understated risk.