BFF5916 · International Banking
Banking Regulation and Basel
Banks are regulated more heavily than almost any other business because their failure is contagious (run → panic → contagion) and they run the payments system the whole economy depends on. The government safety net has two pillars — the lender of last resort (Bagehot: lend freely to solvent-but-illiquid banks) and deposit insurance (in Australia the Financial Claims Scheme guarantees deposits up to $250,000 per account-holder per ADI) — but both create moral hazard: a protected bank levers up and takes more risk, which is the whole reason capital rules exist. The centrepiece is Basel: hold a cushion of loss-absorbing capital sized to the riskiness of your assets, measured by the capital adequacy ratio CAR = total regulatory capital / risk-weighted assets ≥ 8%. Capital comes in a stack — CET1 (the highest quality), AT1 (including CoCos that convert or write down at a trigger) and Tier 2 — with conservation and countercyclical buffers above the 8% minimum and a non-risk-based leverage-ratio backstop. Basel III also added liquidity rules (the LCR for a 30-day stress, the NSFR for a one-year structural match), because a bank can meet its capital ratios and still fail from a run. In Australia the system is twin peaks: APRA (prudential), ASIC (conduct), the RBA and Treasury. Note this chapter is carried entirely by the 40% e-exam — no quiz tests it.
What this chapter covers
- 01Why regulate banks — contagion, the payments system, moral hazard, TBTF
- 02The government safety net — LOLR + deposit insurance (the FCS $250k)
- 03CAMELS — the supervisory rating
- 04Basel I/II/III and the capital stack — CET1, AT1 (CoCos), Tier 2
- 05The capital adequacy ratio — CAR = capital / RWA ≥ 8%, plus buffers
- 06The leverage-ratio backstop (non-risk-based)
- 07Basel III liquidity — LCR and NSFR; the AU twin-peaks structure
Worked example: is the bank adequately capitalised?
- +1Total regulatory capital = 90 + 20 + 30 = $140m.
- +2(a) CET1 ratio = CET1 / RWA = 90 / 1,000 = 9.0% (above the 4.5% CET1 minimum); total CAR = 140 / 1,000 = 14.0%.
- +1(b) Required = 8% + 2.5% = 10.5%. The bank's 14.0% clears it with a 3.5% surplus — adequately capitalised, with room before dividend restrictions bite.
- +1(c) The denominator is RWA, not total assets. Using $1,800m gives a fake CAR of 140/1,800 = 7.8% and would falsely fail the bank.
- +1Stress check: if RWA rose to $1,400m (a riskier book), total CAR = 140/1,400 = 10.0% — now below the 10.5% requirement, so the bank breaches its buffer even though its capital dollars never changed.
Key terms
- Capital adequacy ratio (CAR)
- Total regulatory capital (CET1 + AT1 + Tier 2) divided by risk-weighted assets, required to be at least 8% under Basel plus buffers. The denominator is RWA — assets weighted by risk (cash 0%, mortgages ~50%, corporate loans 100%) — not total assets.
- The capital stack (CET1 / AT1 / Tier 2)
- CET1 (common shares + retained earnings) is the highest-quality, going-concern, loss-absorbing capital; AT1 is hybrid going-concern capital, especially CoCos; Tier 2 (subordinated debt) is gone-concern capital that absorbs losses only in wind-up.
- Contingent convertible (CoCo)
- An AT1 hybrid instrument that writes down or converts to equity automatically when capital falls to a trigger — going-concern bail-in capital that recapitalises a bank without a taxpayer bailout.
- Capital buffers
- Cushions sitting above the 8% minimum — a 2.5% capital conservation buffer, a 0–2.5% countercyclical buffer dialled up in booms, and a G-SIB surcharge. Breaching a buffer doesn't close the bank but triggers automatic restrictions on dividends and bonuses until it rebuilds.
- LCR and NSFR
- Basel III liquidity standards: the Liquidity Coverage Ratio requires enough high-quality liquid assets to survive a 30-day stress; the Net Stable Funding Ratio requires stable funding to match illiquid assets over about a year. They exist because a bank can meet its capital ratios and still fail from a run.
Banking Regulation and Basel FAQ
Why are banks regulated so much more than other businesses?
Two reasons. First, bank failure is contagious: a run on one bank can spread to panic and then system-wide contagion, with large GDP and fiscal costs. Second, banks supply the payments system the whole economy runs on, so 'just let them fail' is rarely an option for a large bank. The safety net that protects depositors then breeds moral hazard, which is why capital requirements exist.
What is the capital adequacy ratio and what goes in it?
CAR = total regulatory capital / risk-weighted assets, and it must be at least 8% under Basel, with buffers on top. Total capital is the stack CET1 + AT1 + Tier 2. The crucial point is the denominator: it is risk-weighted assets (cash 0%, mortgages ~50%, corporate loans 100%), not total assets. Using total assets is the single most common error and would falsely fail a bank.
What is the difference between the CET1 ratio and total CAR?
The CET1 ratio is CET1 / RWA — only the highest-quality capital — and has a lower minimum (4.5%). Total CAR is (CET1 + AT1 + Tier 2) / RWA and has the 8% minimum. They are different ratios with different floors, so don't report one and label it the other. Buffers (the 2.5% conservation buffer and the countercyclical buffer) sit above the 8% total-CAR minimum.
If a bank meets its capital ratios, can it still fail?
Yes — that is precisely why Basel III added liquidity rules. Capital is a static snapshot; a confidence-driven run is a dynamic liquidity event. Recent cases showed banks that met their capital ratios yet failed when uninsured deposits fled and forced fire-sales. The LCR (a 30-day stress test) and the NSFR (a one-year structural match) police the maturity transformation that capital alone does not.
Exam move
This chapter is e-exam-only — no quiz tests it — so weight your revision toward it precisely because it is easy to under-study. Drill the capital-adequacy calculation until it is automatic: CAR = (CET1 + AT1 + Tier 2) / RWA ≥ 8%, and always check against the minimum plus the 2.5% conservation buffer (= 10.5%). Lock the two favourite traps: the denominator is RWA, not total assets, and the CET1 ratio is not the total CAR. Memorise the capital stack (CET1 going-concern → AT1/CoCos going-concern bail-in → Tier 2 gone-concern), the buffers above the minimum, the leverage-ratio backstop, and the two liquidity ratios (LCR 30-day, NSFR one-year). Finish with the Australian twin-peaks map — APRA prudential, ASIC conduct, RBA, Treasury — and the safety-net facts (LOLR; FCS $250k per holder per ADI).
