Basel Capital Framework

🏦 Banking Regulation: The Basel Capital Framework

The Story of Why Banks Need Rules

Imagine you have a piggy bank where your friends give you their allowance to keep safe. You promise to give it back whenever they need it. But what if you spent all their money on candy, and suddenly everyone wants their allowance back at the same time?

Uh oh! 😱

This is exactly why we have bank regulations — rules that make sure banks always have enough money to pay everyone back!

🌍 Bank Regulation Overview

Why Do Banks Need Rules?

Think of banks like babysitters for money. When you hire a babysitter, you want to make sure they’re responsible, right? You don’t want them to throw a party with your house keys!

Banks hold trillions of dollars of people’s savings. Without rules:

• Banks might make risky bets with your money
• If banks fail, regular people lose their savings
• The whole economy could crash (like dominoes falling!)

Who Makes These Rules?

Different countries have their own bank regulators (like school principals for banks):

• 🇺🇸 USA: Federal Reserve, OCC
• 🇬🇧 UK: Bank of England
• 🇪🇺 Europe: European Central Bank

But they all follow a common rulebook called Basel!

🏛️ Basel Framework Overview

What is Basel?

Basel is a city in Switzerland 🇨🇭 where important people from banks all over the world meet to create rules. It’s like the United Nations, but for banking!

graph TD
    A["Basel Committee"] --> B["Creates Global Rules"]
    B --> C["Countries Adopt Rules"]
    C --> D["Banks Follow Rules"]
    D --> E[Everyone's Money is Safe!]

The Three Basel Agreements

Think of Basel like a video game with three levels — each one stronger than the last!

Real Example: After the 2008 financial crisis (when big banks like Lehman Brothers failed), world leaders said: “We need tougher rules!” That’s why Basel III was created.

💰 Basel III Capital Requirements

The Big Idea: Always Have Backup Money!

Imagine you run a lemonade stand. You make $100, but you don’t spend it all. You keep $10 in a jar “just in case” lemons get expensive or nobody buys lemonade tomorrow.

Basel III tells banks: “Keep money in your safety jar!”

The Magic Numbers

Basel III says banks must keep at least these amounts:

graph TD
    A["Total Capital<br>8% minimum"] --> B["Tier 1 Capital<br>6% minimum"]
    B --> C["Common Equity Tier 1<br>4.5% minimum"]
    A --> D["Tier 2 Capital<br>2% maximum"]

What Do These Percentages Mean?

Simple Example:

If a bank has $100 in loans (money they lent out), they must keep:

• $4.50 in the strongest capital (CET1)
• $6.00 total in Tier 1 capital
• $8.00 total in all capital

It’s like saying: “For every $100 you risk, keep $8 safe!”

Extra Safety Buffers 🛡️

Basel III added extra cushions (like wearing a helmet AND knee pads):

Real Example: JPMorgan Chase is so huge that if it failed, the whole economy would shake. So it must keep EXTRA capital beyond the basic requirements!

🧱 Bank Capital Components

What Counts as “Capital”?

Not all money is created equal! Bank capital comes in different “flavors” — some stronger than others.

Tier 1 Capital: The Super Strong Stuff 💪

This is money the bank truly owns — it doesn’t have to pay it back to anyone!

What’s included:

1. Common Equity (CET1) — The strongest!

   • Regular shares (when people buy stock)
   • Retained earnings (profits the bank kept)

2. Additional Tier 1 (AT1)

   • Special bonds that can turn into shares if things go bad

Simple Example: Think of CET1 like the foundation of a house — it’s the strongest part that holds everything up. If the house shakes, the foundation stays solid!

Tier 2 Capital: The Helper Money 🤝

This is weaker capital — it helps, but it’s not as reliable.

What’s included:

• Subordinated debt (loans that get paid last if bank fails)
• Some loan loss reserves

Example: If a bank fails and has to pay everyone back:

1. First, regular depositors get paid
2. Then, bondholders get paid
3. Last, Tier 2 holders get paid (if anything’s left!)

The Capital Stack

graph TD
    A["🏔️ STRONGEST"] --> B["Common Equity Tier 1<br>Shares + Retained Profits"]
    B --> C["Additional Tier 1<br>Special Convertible Bonds"]
    C --> D["Tier 2 Capital<br>Subordinated Debt"]
    D --> E["🌊 WEAKEST"]

⚖️ Risk-Weighted Assets (RWA)

Why All Loans Aren’t Equal

Here’s a puzzle: If a bank lends $100 to…

• The US Government 🇺🇸
• A brand new restaurant 🍕

…which one is riskier?

Obviously the restaurant! The government almost never fails to pay, but restaurants close all the time.

The Brilliant Idea: Weight Your Risks!

Basel says: Don’t treat all $100 loans the same. Weight them by risk!

How RWA Works: A Story

Bank ABC has:

• $1,000 in government bonds (risk weight: 0%)
• $1,000 in home loans (risk weight: 35%)
• $1,000 in business loans (risk weight: 100%)

Calculate RWA:

• Government: $1,000 × 0% = $0
• Homes: $1,000 × 35% = $350
• Business: $1,000 × 100% = $1,000
• Total RWA = $1,350

Capital needed (8%): $1,350 × 8% = $108

Even though the bank has $3,000 in total assets, they only need $108 in capital because much of it is low-risk!

Why This Matters

graph TD
    A["Safe Loan?"] -->|Yes| B["Low Risk Weight"]
    A -->|No| C["High Risk Weight"]
    B --> D["Need Less Capital"]
    C --> E["Need More Capital"]
    D --> F["Bank Can Lend More!"]
    E --> G["Bank Must Be Careful"]

Real Example: If a bank wants to make risky loans to startups, it must keep MORE capital. This makes banks think twice before making super risky bets!

🎯 Putting It All Together

The Basel III Formula

Here’s how it all connects:

Capital Ratio = Total Capital ÷ Risk-Weighted Assets

Must be at least 8%!

Example:

• Bank has $10 million in capital
• Bank has $100 million in risk-weighted assets
• Ratio = $10M ÷ $100M = 10% ✅ (Above 8%, they’re safe!)

Why This System Works

1. Banks must save → They can’t gamble with ALL your money
2. Risky stuff costs more → Banks think carefully before risky loans
3. Everyone plays fair → Same rules worldwide

🌟 Key Takeaways

The One Sentence Summary

Basel III makes banks keep enough “safety money” based on how risky their loans are, so they can always pay you back!

🚀 You’re Ready!

Now you understand why banks can’t just do whatever they want with your money. The Basel Framework is like a safety net for the entire global economy!

Remember: Every time you deposit money in a bank, there are rules making sure it stays safe. That’s Basel at work! 🏦✨