How is Basel III regulatory capital structured, and what is the loss-absorption waterfall?

Question

AcadiFi · Accepted Answer

Basel III capital structure is one of the most heavily tested FRM Part II topics. The framework creates a hierarchy of loss-absorbing instruments, with the highest-quality capital absorbing losses first. Understanding the waterfall — which layers take losses in which order — is essential.

```mermaid
graph TD
  A[Total Loss-Absorbing Capacity - TLAC] --> B[Tier 2 Capital]
  B --> C[Additional Tier 1 - AT1]
  C --> D[CET1 Buffers]
  D --> E[CET1 Minimum 4.5%]
  E --> F[Losses Hit Here First]
  D --> D1[Capital Conservation Buffer 2.5%]
  D --> D2[Countercyclical Buffer 0-2.5%]
  D --> D3[G-SIB Surcharge 1.0-3.5%]
  subgraph Loss Absorption Order
    F -->|1st| E
    E -->|2nd| D
    D -->|3rd| C
    C -->|4th| B
    B -->|5th| A
  end
  style E fill:#8b2020,color:#fff
  style D fill:#c9a84c,color:#0a0a0f
  style C fill:#1e3a5f,color:#fff
  style B fill:#2d1b4e,color:#fff
  style A fill:#1a3c2a,color:#fff
```

**Capital Components Explained:**

**CET1 (Common Equity Tier 1) — Minimum 4.5% of RWA**
The highest quality capital: common shares, retained earnings, and accumulated other comprehensive income (AOCI). This is the first line of defense.

At Ridgeline Global Bank:
- Common shares issued: $18 billion
- Retained earnings: $12 billion
- Regulatory deductions (goodwill, DTAs, etc.): ($4 billion)
- **CET1 Capital: $26 billion**
- Risk-Weighted Assets (RWA): $320 billion
- **CET1 Ratio: 26/320 = 8.13%**

**CET1 Buffers (on top of the 4.5% minimum):**

| Buffer | Rate | Purpose |
|---|---|---|
| Capital Conservation Buffer (CCB) | 2.5% fixed | Absorbs losses in stress; breaching triggers dividend restrictions |
| Countercyclical Buffer (CCyB) | 0-2.5% variable | Set by national regulators during credit booms |
| G-SIB Surcharge | 1.0-3.5% | Extra buffer for globally systemically important banks |
| D-SIB Surcharge | Varies | For domestically systemically important banks |

Ridgeline is a G-SIB with a 2.0% surcharge and operates where CCyB is 1.0%:
- Total CET1 requirement: 4.5% + 2.5% + 1.0% + 2.0% = **10.0%**
- Ridgeline's 8.13% is **below** the fully buffered requirement, triggering automatic restrictions on dividends, buybacks, and bonuses

**Additional Tier 1 (AT1) — Minimum 1.5% of RWA**
Contingent convertible bonds (CoCos) and perpetual preferred shares. These instruments must have a loss-absorption trigger — typically converting to equity or being written down when the CET1 ratio falls below 5.125%.

Ridgeline's $8 billion in AT1 CoCos would convert to common equity if its CET1 ratio drops below 5.125%, instantly boosting CET1.

**Tier 2 Capital — Minimum 2.0% of RWA**
Subordinated debt with at least 5-year original maturity, loan loss reserves (up to a cap), and revaluation reserves. Less loss-absorbing than AT1 because it absorbs losses only in liquidation.

**TLAC (Total Loss-Absorbing Capacity):**
For G-SIBs, the FSB requires total loss-absorbing capacity of at least 18% of RWA (or 6.75% of the leverage exposure measure). TLAC includes senior unsecured debt that can be bailed in during resolution.

**The Loss Waterfall in Practice:**
1. Losses first erode CET1 (retained earnings wiped out)
2. Buffers are consumed, triggering automatic distribution restrictions
3. AT1 instruments convert or write down when CET1 breaches the trigger
4. In resolution, Tier 2 debt is written down or converted
5. TLAC-eligible senior debt is bailed in as a last resort before taxpayer support

**Exam Tip:** The FRM exam tests three common areas: calculating each ratio (CET1/AT1/Total Capital/TLAC), understanding what happens when buffers are breached (restrictions, not closure), and knowing the conversion triggers for AT1 instruments.

Master Basel III capital calculations with our FRM Part II practice questions on AcadiFi.

How is Basel III regulatory capital structured, and what is the loss-absorption waterfall?

Master Part II with our FRM Course

Related Questions

Practice Questions