Capital Relief and Regulatory Capital under Basel III/IV
Introduction
In the modern banking system, capital relief and the rules governing regulatory capital play a central role in ensuring financial stability. Following the global financial crisis of 2007–2009, regulators around the world recognized the need for a stricter framework to strengthen banks’ resilience against unexpected shocks. This led to the development and implementation of the Basel III framework, followed by ongoing refinements often referred to as Basel IV or Basel 3.1. These reforms are designed to make banks safer, improve transparency, and protect the global financial system.
What Is Regulatory Capital?
Regulatory capital is the minimum amount of capital that banks are required to hold by financial regulators. It acts as a cushion against losses and ensures that banks can absorb shocks without collapsing. Regulatory capital is categorized into tiers:
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Common Equity Tier 1 (CET1): the highest quality capital, primarily consisting of common shares and retained earnings.
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Additional Tier 1 (AT1): hybrid instruments like contingent convertible bonds (CoCos) that can absorb losses in stress scenarios.
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Tier 2 Capital: subordinated debt and other instruments that provide additional protection.
Holding sufficient regulatory capital reassures depositors, investors, and regulators that a bank can survive downturns.
Capital Relief Explained
Capital relief occurs when banks are able to reduce the amount of regulatory capital they must hold against their exposures. This can be achieved through risk transfer, securitization, hedging, or other risk management tools. The purpose of capital relief is to free up capital that banks can then use for lending, investment, or other activities.
For example, a bank with a large portfolio of loans may engage in significant risk transfer (SRT) transactions by selling the credit risk of that portfolio to investors. This reduces the risk-weighted assets (RWAs) on its balance sheet, thereby lowering its required regulatory capital. However, regulators remain cautious to ensure such relief mechanisms do not mask underlying risks.
Basel III: Strengthening the Rules
The Basel III framework, introduced in 2010 and phased in over the following decade, focused on four key pillars:
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Higher capital requirements – Banks must hold more CET1 capital relative to their risk-weighted assets.
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Leverage ratio – A simple, non-risk-based measure to prevent excessive borrowing.
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Liquidity standards – Minimum requirements such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).
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Capital conservation and countercyclical buffers – Extra cushions designed to absorb losses in times of stress.
These reforms made the banking sector more resilient but also increased the cost of capital for banks, pushing them to seek efficient ways to achieve capital relief.
Basel IV (Basel 3.1): The Next Step
Although often referred to as Basel IV, regulators emphasize that this is not a completely new framework but a finalization of Basel III rules. Basel IV introduces several major adjustments, including:
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Revised standardised approaches for credit, market, and operational risk.
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Output floor: a minimum threshold to limit how much lower banks’ internal risk models can reduce capital requirements compared to standardized approaches.
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More risk sensitivity in how RWAs are calculated, ensuring greater comparability across banks and jurisdictions.
These changes will reduce variability in RWAs, improve transparency, and strengthen market confidence. However, they also limit the extent of capital relief that banks can obtain from internal modeling or complex transactions.
Capital Relief vs. Regulatory Scrutiny
While capital relief mechanisms, such as securitizations, derivatives, and risk transfers, remain valuable tools, supervisors such as the European Central Bank (ECB), the Prudential Regulation Authority (PRA), and the Basel Committee on Banking Supervision (BCBS) have increased their oversight.
Regulators are concerned about:
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Interconnectedness: when banks lend to investors who also buy their risk transfer instruments.
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Concentration risk: reliance on a small group of investors or counterparties.
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Systemic risk: excessive use of risk transfers masking weak capital generation.
As Basel IV takes hold, regulators expect banks to balance capital relief with strong capital quality, prioritizing CET1 capital rather than relying excessively on complex structures.
The Future of Capital Relief under Basel IV
Looking ahead, capital relief will continue to be an essential part of bank capital management. However, the stricter output floor, tougher scrutiny on internal ratings-based (IRB) models, and more conservative assumptions in risk measurement will limit the scope for aggressive optimization.
Banks will likely:
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Expand their use of synthetic securitizations and SRTs for genuine risk transfer.
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Diversify their investor base to mitigate concentration risks.
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Strengthen collateral and counterparty risk management.
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Integrate capital planning more closely with business strategy, ensuring sustainable growth within regulatory limits.
Conclusion
Capital relief and regulatory capital are at the heart of modern banking. Basel III and Basel IV reforms have raised the bar for banks worldwide, demanding higher quality capital, stricter measurement of risk, and more transparency. While capital relief remains a powerful tool, its use is increasingly bounded by regulation and supervisory oversight. The challenge for banks is to balance efficiency with resilience, ensuring they can thrive in competitive markets without compromising financial stability.
