Basel III: CET1, Tier 1, Total Capital, and Risk-Weighted Assets

Introduction

Basel III is the international regulatory framework that determines how much capital banks must hold against their risk exposures, and it is the single most important set of rules governing the FIG universe. Developed by the Basel Committee on Banking Supervision after the 2008 financial crisis, Basel III defines what qualifies as capital (the numerator), how to measure risk (the denominator, risk-weighted assets), and the minimum ratios that connect the two. The framework creates a layered capital stack: CET1 at the top (the highest-quality, loss-absorbing equity), Additional Tier 1 below (perpetual instruments with loss-absorption triggers), and Tier 2 at the base (subordinated debt that absorbs losses in resolution). On top of the minimums sit buffers that push practical CET1 requirements for the largest US banks to 10-13%, far above the headline 4.5% minimum that appears in textbooks. Understanding this framework is the prerequisite for every FIG valuation, every DDM payout assumption, and every M&A capital adequacy analysis in the sector.

Basel III capital is organized by loss-absorption quality, with the highest-quality capital required in the largest proportion.

Common Equity Tier 1 (CET1)

CET1 is the bedrock of bank solvency. It consists of common shares issued by the bank, retained earnings, accumulated other comprehensive income (AOCI), and other disclosed reserves, minus regulatory deductions: goodwill, deferred tax assets above thresholds, and certain intangible assets. CET1 must be permanent, fully paid-in, and rank last in liquidation. It absorbs losses immediately on a going-concern basis, meaning the bank continues operating while losses are written against common equity.

The minimum CET1 ratio (CET1 capital divided by risk-weighted assets) is 4.5%. But this is only the floor. Layered buffers push effective requirements much higher.

Additional Tier 1 (AT1)

AT1 sits one level below CET1 in the loss-absorption hierarchy. Qualifying instruments must be perpetual (no fixed maturity), pay non-cumulative dividends or coupons, and contain a loss-absorption mechanism that activates before CET1 falls below a trigger level. In Europe, AT1 is issued primarily as CoCo bonds (contingent convertible bonds) with coupon rates of 6-10%. If the issuing bank's CET1 ratio falls below a pre-set trigger (typically 5.125% or 7%), the instrument either converts into equity at a formula price or is written down to zero. The 2023 Credit Suisse resolution demonstrated the extreme case: approximately CHF 17 billion of AT1 CoCos were written to zero while equity holders received a small consideration from UBS, inverting the normal seniority ladder and causing significant market disruption.

In the US, AT1 is issued almost entirely as perpetual non-cumulative preferred stock. There is no automatic trigger conversion; instead, loss absorption occurs through regulatory discretion (regulators can block preferred dividends under stress) and through the Orderly Liquidation Authority in resolution. The minimum Tier 1 ratio (CET1 + AT1, divided by RWA) is 6.0%.

Tier 2

Tier 2 is "gone-concern" capital that absorbs losses in resolution, after the bank has failed but before depositors and senior creditors take losses. Qualifying instruments include subordinated debt with original maturity of at least five years (subject to a straight-line amortization haircut in the final five years), certain loan-loss reserves up to 1.25% of RWA, and eligible hybrid instruments. The minimum Total Capital ratio (Tier 1 + Tier 2, divided by RWA) is 8.0%.

Risk-Weighted Assets (RWA)

Risk-weighted assets translate a bank's balance sheet into a risk-adjusted measure by multiplying each asset's book value by a prescribed risk weight. US Treasuries and Fed reserves carry a 0% risk weight (considered riskless), agency MBS and GSE obligations carry 20%, first-lien residential mortgages carry 50%, standard corporate loans carry 100%, and speculative or below-investment-grade exposures carry 150%. A bank holding $100 billion in Treasuries adds zero to RWA, while $100 billion in corporate loans adds $100 billion. Off-balance-sheet commitments (credit lines, guarantees) are first converted to on-balance-sheet equivalents using credit conversion factors, then risk-weighted. RWA is the denominator in all capital ratios, which means that a bank can improve its CET1 ratio either by raising more capital (numerator) or by reducing the riskiness of its assets (denominator), the latter explaining why banks sell or securitize risky loans to optimize capital.

The Basel III minimum of 4.5% CET1 is a theoretical floor that no well-managed bank operates anywhere near, because multiple buffers layer on top.

Capital Conservation Buffer (CCoB): 2.5% of RWA, composed entirely of CET1. Banks that dip into this buffer face automatic restrictions on dividends, share buybacks, and discretionary bonus payments through the Maximum Distributable Amount (MDA) framework. A bank with CET1 exactly at 4.5% can pay out zero. The buffer creates a graduated restriction zone between 4.5% and 7.0%.

Countercyclical Capital Buffer (CCyB): Ranges from 0% to 2.5% of RWA, set by national regulators and designed to build capital during credit booms and release it during downturns. The Federal Reserve has maintained the US CCyB at 0% since its introduction and has never activated it. Other jurisdictions have used it: Sweden set it as high as 2.5% before cutting to zero during COVID.

[Stress Capital Buffer (SCB)](/guides/fig-investment-banking/stress-tests-ccar-stress-capital-buffer): A US-specific buffer that replaces the old CCAR capital plan rule. The SCB equals each bank's maximum CET1 decline in the Fed's severely adverse stress test scenario, floored at 2.5%. It incorporates four quarters of planned dividends. Banks with stress-resilient portfolios (JPMorgan: 2.5% SCB at the floor) have lower requirements than banks with volatile trading books or concentrated credit exposures.

[G-SIB Surcharge](/guides/fig-investment-banking/gsib-surcharges-tlac-requirements): An additional CET1 buffer for the eight US globally systemically important banks, calculated from five categories of systemic importance indicators.

The risk-weighted framework is vulnerable to manipulation through model choices and asset selection. The leverage ratio provides a blunt backstop by applying no risk weights.

The standard leverage ratio divides Tier 1 capital by total on-balance-sheet assets, with a minimum of 4% for well-capitalized US banks. The Supplementary Leverage Ratio (SLR) uses a broader denominator: Tier 1 capital divided by total leverage exposure, which includes on-balance-sheet assets plus derivatives (at replacement cost plus potential future exposure), repo and securities financing gross-ups, and off-balance-sheet commitments. The minimum SLR is 3% for large banks. The Enhanced SLR (eSLR) requires G-SIB holding companies to exceed 5% and their insured depository subsidiaries to exceed 6%.

The leverage ratio matters most for banks with low RWA density. A bank holding large books of US Treasuries, agency securities, or cleared derivatives has low or zero risk weights on those assets but full leverage exposure. Such a bank may be flush on risk-weighted metrics but constrained by the leverage ratio, a dynamic that has limited banks' capacity to intermediate the Treasury market.

Every strand of FIG analysis connects back to the capital framework. The CET1 ratio determines the DDM payout constraint: a bank cannot distribute earnings that would bring CET1 below requirements plus buffers. The capital requirement determines cost of equity: higher requirements mean more equity funding, which may increase the return investors demand for the incremental capital at risk. And the capital treatment of goodwill (deducted from CET1) constrains M&A pricing: a bank paying 1.5x book value for a target creates goodwill equal to 0.5x the target's book, which is deducted dollar-for-dollar from the acquirer's CET1, reducing its capital ratio and potentially constraining future capital return.

The excess return model provides the theoretical link: if higher capital requirements force a bank to hold more equity without earning a proportionally higher return, ROE declines, excess returns compress, and P/TBV should fall. This is the channel through which capital regulation directly affects bank valuation, and it explains why the Basel III Endgame debate generated such intense industry opposition: higher capital requirements, all else equal, reduce ROE and compress bank multiples.

AT1 and Tier 2 instruments also affect the FIG banker's work directly. Capital raises in FIG are dominated by Tier 2 subordinated debt issuance, AT1/preferred stock offerings, and TLAC-eligible senior unsecured bonds. Understanding which instruments qualify at each tier, and the relative cost of each, is essential for advising banks on optimal capital structure.

Basel III is the foundation on which the entire regulatory section builds. The G-SIB surcharge and TLAC requirements layer additional obligations on the largest banks. Stress tests determine the stress capital buffer dynamically each year. Basel III Endgame represents the final (and still contested) iteration of the post-crisis framework. And the excess capital that remains after satisfying all requirements and buffers is the capacity that drives dividends, buybacks, and M&A, the core advisory questions for FIG bankers.