Understanding Bank Solvency and Basel Accords

Posted on May 28, 2026 in Finance, Banking, and Insurance

Bank Solvency Fundamentals

Solvency is a bank’s ability to cover the risk of its assets with sufficient capital. The solvency ratio is calculated as Capital / RWA ≥ 8%. If the ratio falls below this threshold, the bank does not comply with regulatory requirements.

Capital Categories

  • CET1: Highest-quality capital, including ordinary shares, reserves, and retained earnings.
  • AT1: Loss-absorbing instruments, primarily CoCos.
  • Tier 1: CET1 + AT1.
  • Tier 2: Lower-quality capital, such as subordinated debt, preferred shares, revaluation reserves, and general provisions.
  • Total Capital: CET1 + AT1 + Tier 2.

Basel I Framework

Basel I established a minimum solvency ratio of 8% using RWA (Risk-Weighted Assets), calculated as: RWA = Asset × Risk Weight.

Basel I Risk Weights

  • EU states and central banks: 0%
  • Mortgage bonds: 10%
  • Regional governments, local authorities, and banks: 20%
  • Mortgage loans secured by housing: 50%
  • Other assets: 100%

Exam Exercise Steps

  1. Classify each asset.
  2. Apply the appropriate risk weight.
  3. Sum the RWA.
  4. Calculate the solvency ratio.
  5. Compare the result with the 8% requirement.

Improving the Solvency Ratio

  • Increase Capital: Issue shares, retain profits, or issue CoCos/subordinated debt.
  • Reduce RWA: Sell risky assets, reduce 100%-weighted loans, acquire safer assets, or reduce off-balance-sheet exposures.

Basel II: Risk Sensitivity

Basel II introduced greater risk sensitivity than Basel I, incorporating improved credit risk measurement, operational risk, external ratings, and internal models.

  • Operational Risk: Losses caused by failures in processes, people, systems, or external events.
  • Standardised Approach: Uses external ratings to assign risk weights.
  • IRB Approach: Banks use internal models to assess borrower risk, subject to regulatory approval and supervision.

Basel III: Strengthening Regulation

Introduced after the 2008 crisis, Basel III focuses on capital quality, liquidity, leverage control, and risk management.

Minimum Capital Requirements

  • CET1 Ratio: CET1 / RWA ≥ 4.5%
  • Tier 1 Ratio: (CET1 + AT1) / RWA ≥ 6%
  • Total Capital Ratio: (CET1 + AT1 + Tier 2) / RWA ≥ 8%

Buffers and Leverage

  • Capital Conservation Buffer: Extra 2.5% CET1 to absorb losses during stress periods.
  • Countercyclical Buffer: 0%–2.5% CET1, applied when excessive credit growth creates systemic risk.
  • Leverage Ratio: CET1 / Total unweighted assets > 3%. This uses unweighted assets to limit excessive leverage.

Basel III Pillars

  • Pillar 1: Capital requirements, risk coverage, leverage, and liquidity.
  • Pillar 2: Supervision, risk management, and corporate governance.
  • Pillar 3: Market discipline and disclosure requirements.

Liquidity and Systemic Importance

  • LCR (Liquidity Coverage Ratio): High-Quality Liquid Assets / Net liquidity outflows over 30 days ≥ 100%. This ensures the bank can survive 30 days of liquidity stress.
  • NSFR (Net Stable Funding Ratio): A long-term liquidity ratio preventing banks from financing long-term assets with excessive short-term debt.
  • SIFIs / G-SIBs: Systemically important banks. These require extra CET1 (1%–2.5%) because their failure could damage the financial system.

Basel IV (Basel 3.5)

Basel IV modifies how RWA are calculated to make risk assessments more transparent, comparable, and less dependent on internal models. It restricts internal models and introduces a capital floor, ensuring capital requirements do not fall significantly below the standardised approach” } .