Purpose and Evolution
The Basel Framework is applied on a consolidated basis to internationally active banks. Consolidated supervision is the best means to provide supervisors with a comprehensive view of risks and to reduce opportunities for regulatory arbitrage.
Core Objective
The core objective is to reduce the probability of bank failures by increasing their going-concern loss-absorbency. For Global Systemically Important Banks (G-SIBs), the framework aims to reduce the extent or impact of their failure on the global financial system and wider economy.
This is approached via a global, system-wide, loss-given-default (LGD) concept rather than merely a probability of default (PD) concept.
G-SIB and D-SIB Metrics
Systemic importance for Global and Domestic Systemically Important Banks (G-SIBs and D-SIBs) is measured using multiple indicator-based approaches across categories like:
- Size: Total exposures.
- Cross-jurisdictional activity: Claims and liabilities globally.
- Interconnectedness: Intra-financial system assets/liabilities.
- Substitutability: Financial institution infrastructure.
- Complexity: OTC derivatives, Level 3 assets.
Key Elements of the Framework
Definition of Capital (CAP)
It is critical that banks' risk exposures are backed by a high-quality capital base. The framework categorizes eligible capital into three tiers:
- Common Equity Tier 1 (CET1): The predominant form of Tier 1 capital, comprising common shares and retained earnings. Represents the most subordinated claim in liquidation.
- Additional Tier 1 (AT1): Instruments that are perpetual, with no step-ups or incentives to redeem, absorbing losses on a going-concern basis.
- Tier 2 Capital: Provides loss absorption on a gone-concern basis, subordinated to depositors and general creditors.
Risk-Based Capital Buffers (RBC)
To ensure banks can absorb losses during periods of financial stress, the framework establishes mandatory buffers above the regulatory minimum:
- Capital Conservation Buffer: 2.5%, comprised entirely of CET1. Capital distribution constraints (like dividend limits) are imposed if capital falls into this range.
- Countercyclical Buffer: Extends the conservation buffer to protect against periods of excess aggregate credit growth.
Market Risk (MAR)
Trading book instruments are subject to capital requirements against default risk, interest rate risk, equity risk, foreign exchange (FX) risk, and commodities risk.
Calculated via either the Standardised Approach (Sensitivities-based method: Delta, Vega, Curvature) or the Internal Models Approach (IMA) for eligible trading desks.
Credit Risk (CRE)
The largest component of Risk-Weighted Assets. Credit risk addresses unexpected losses (UL) from exposures ranging from corporate loans, retail portfolios, residential real estate, to specialised lending (project/object finance).
Operational Risk (OPE)
Addresses the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events (including ICT and cyber risks). It is calculated using the operational risk standardised approach through the Business Indicator.
Liquidity & Leverage (LCR/LEV)
Alongside risk-weighted capital, the framework mandates a non-risk-based Leverage Ratio to restrict the build-up of excessive leverage. It also enforces liquidity standards like the Liquidity Coverage Ratio (LCR) to ensure banks hold sufficient High-Quality Liquid Assets (HQLA).
Measuring Risk: Standardised vs IRB
The Standardised Approach
Assigns fixed standardised risk weights to exposures based on counterparty type, external credit ratings (where permitted), and specific asset classifications.
- ✓ Bank Exposures: Can range from 20% (Grade A/AAA) to 150% (Grade C/Below B-).
- ✓ Corporate Exposures: Unrated exposures generally receive a 100% risk weight (85% for SMEs).
- ✓ Residential Real Estate: Weighted according to Loan-to-Value (LTV) ratios.
Internal Ratings-Based (IRB)
Subject to supervisory approval, banks use their own internal estimates of risk components to determine capital requirements for unexpected loss (UL).
- → Foundation IRB (F-IRB): Banks provide own estimates of Probability of Default (PD). Supervisors provide LGD, EAD, and Maturity (M).
- → Advanced IRB (A-IRB): Banks provide internal estimates of PD, Loss Given Default (LGD), and Exposure at Default (EAD).
The Output Floor (RBC20.13)
To ensure a level playing field, the Basel Framework mandates an output floor. Even if a bank's internal models suggest extremely low risk, their total Risk-Weighted Assets (RWA) calculated under internally modelled approaches cannot fall below 72.5% of the RWA calculated using the Standardised Approaches.
Community Bank Capital Modeler
Explore how moving from the Standardised Approach to an approved IRB Model impacts a bank's Risk-Weighted Assets (RWA), Capital Requirements, and Return on Equity (ROE). Adjust the Probability of Default (PD) below to see how internal ratings dynamically change the IRB Risk Weight.
Loan Portfolio Mix
Standardised
Risk-Weighted Assets (RWA)
$0M
Required Capital (10.5%)
$0M
Return on Equity
0.00%
Internal Ratings-Based
Risk-Weighted Assets (RWA)
$0M
72.5% Floor ActiveRaw IRB Est: $0M
Required Capital (10.5%)
$0M
Return on Equity
0.00%
Model Impact Analysis
Under the Standardised approach, risk weights are static (RWA: $0M). Under the IRB approach, internal parameters like PD and LGD directly shift the Raw IRB RWA estimate to $0M.
Without the 72.5% output floor, this would boost Return on Equity (ROE) from 0.00% to 0.00%.
However, the Basel output floor is currently active, clamping the final IRB RWA at $0M and capping the final ROE at 0.00% to ensure systemic safety regardless of internal model estimates.
Because the raw estimate is above the 72.5% output floor, the final IRB RWA remains $0M and the final ROE is 0.00%.