CFA Level II Exam · Analysis of Financial Institutions

Basel III Capital Adequacy and Regulatory Ratios for CFA Level II

Updated 6 October 2026 · Fact-checked

Capital adequacy rules make banks hold enough loss-absorbing capital and liquidity. You divide regulatory capital (CET1, Tier 1, total) by risk-weighted assets, divide Tier 1 by total exposure for the leverage ratio, and test liquidity with LCR (HQLA ÷ 30-day net outflows) and NSFR (available ÷ required stable funding). Compare each result with its minimum.

Understand Capital Adequacy and Regulatory Ratios

A bank funds itself mostly with other people's money: deposits and borrowings. If its assets lose value, someone must absorb the loss. Capital is the cushion that takes losses first, before depositors. Regulators set rules, the Basel framework, so that banks in different countries hold a minimum cushion.

Capital is ranked by quality. Common Equity Tier 1 (CET1) is the best: common shares and retained earnings, less deductions such as goodwill and other intangibles. Additional Tier 1 (AT1) is perpetual, loss-absorbing instruments such as certain contingent or non-cumulative securities. CET1 plus AT1 is Tier 1, the going-concern capital that absorbs losses while the bank keeps operating. Tier 2 is gone-concern capital: it absorbs losses mainly when the bank fails. Typical items are subordinated debt with a long original maturity and limited general provisions. Tier 1 plus Tier 2 is total capital.

Capital is measured against risk-weighted assets (RWA). A government bond carries a low risk weight and an unsecured corporate loan a higher one, so two banks with equal assets can need different capital. Under Basel III the minimums are 4.5% CET1, 6% Tier 1 and 8% total capital, all as a percentage of RWA. A capital conservation buffer of 2.5% (in CET1) sits on top. A countercyclical buffer can be added by national regulators in a credit boom, and the largest banks face extra surcharges. If a bank dips into buffers, it faces limits on dividends and bonuses.

Risk weights can be gamed or modelled wrongly, so Basel III adds a simple backstop: the leverage ratio, Tier 1 capital divided by total (mostly unweighted) exposure, with a 3% minimum. It ignores risk weights on purpose.

Capital does not stop a run on a bank, so Basel III adds two liquidity tests. The liquidity coverage ratio (LCR) is a 30-day stress test: high-quality liquid assets must cover net cash outflows. The net stable funding ratio (NSFR) is a one-year structural test: stable funding must support long-term assets. Both must be at least 100%. In the exam, minimums are usually stated or implied in the vignette, so your job is to compute correctly and interpret.

Key formulas to remember

CET1 capital: CET1 = common equity (shares + retained earnings + other reserves) − regulatory deductions; Deductions include goodwill and other intangibles. Always deduct them before computing any ratio.
Tier 1 and total capital: Tier 1 = CET1 + Additional Tier 1; Total capital = Tier 1 + Tier 2; Tier 1 is going-concern capital. Tier 2 is gone-concern capital.
Risk-based capital ratios: Ratio = capital measure ÷ risk-weighted assets; Basel III minimums: CET1 4.5%, Tier 1 6%, total capital 8%. Use the matching numerator for each ratio.
Capital conservation buffer: CET1 needed = 4.5% + 2.5% = 7.0% of RWA; Add any countercyclical or surcharge buffer the vignette gives. Falling into the buffer restricts distributions.
Leverage ratio: Leverage ratio = Tier 1 capital ÷ total exposure; Minimum 3% under Basel III. Not risk-weighted.
Liquidity coverage ratio: LCR = stock of high-quality liquid assets ÷ total net cash outflows over 30 days ≥ 100%; Net outflows = outflows − inflows, with inflows capped at 75% of outflows. HQLA is after haircuts.
Net stable funding ratio: NSFR = available stable funding ÷ required stable funding ≥ 100%; Looks at a one-year horizon. Stable funding means capital and long-term, sticky liabilities.
Capital headroom: Headroom (currency) = (actual ratio − required ratio) × RWA; Useful when the question asks how much capital a bank can lose or distribute.

How to solve Capital Adequacy and Regulatory Ratios questions

Use this method for any question on Basel capital, leverage or liquidity ratios.

1Identify what the question asks: a risk-based capital ratio, leverage ratio, LCR, NSFR, or an interpretation of one.
2Pull the numbers from the vignette and exhibits. Note whether each item is capital, RWA, exposure, HQLA, outflows, inflows or funding.
3For capital, start from common equity and subtract goodwill, intangibles and other stated deductions to get CET1. Then add AT1 for Tier 1 and Tier 2 for total capital.
4Pick the right denominator: RWA for CET1, Tier 1 and total capital ratios; total exposure for the leverage ratio.
5For LCR, compute net outflows first (outflows minus inflows, applying the 75% cap on inflows if it binds), then divide HQLA by it.
6For NSFR, divide available stable funding by required stable funding. Do not mix this with the 30-day LCR items.
7Compare with the minimum plus any buffers. State the result as meets or fails, and give headroom or shortfall if asked.
8Check the answer for sense: a ratio far from typical levels often signals a wrong numerator or denominator.

Quickest way: Numerator, denominator, threshold

When to use it: When you have about a minute per question and the vignette gives clean numbers.

Write the ratio name and its threshold: CET1 4.5% (7.0% with buffer), Tier 1 6%, total 8%, leverage 3%, LCR and NSFR 100%.
Circle the one numerator and one denominator in the exhibit. Ignore other lines.
Deduct goodwill and intangibles from CET1 before anything else.
Divide, then compare. For headroom multiply the gap by RWA.
Eliminate options that reverse the direction, for example a ratio below 100% described as passing.

Common mistakes in Capital Adequacy and Regulatory Ratios

Forgetting to deduct goodwill and intangibles from common equity
Candidates take total equity from the balance sheet as CET1.
Fix: Regulatory capital is not accounting equity. Subtract the deductions listed in the vignette first.
Using total assets instead of risk-weighted assets as the denominator of the capital ratios
The leverage ratio uses unweighted exposure, so the two are confused.
Fix: Risk-based ratios use RWA. Only the leverage ratio uses total exposure.
Treating Tier 2 as part of Tier 1
Both are called capital and the names sound alike.
Fix: Tier 1 = CET1 + AT1 (going concern). Tier 2 is separate and only adds to total capital.
Mixing up LCR and NSFR
Both are liquidity ratios with a 100% minimum.
Fix: LCR: liquid assets versus 30-day stressed net outflows. NSFR: stable funding versus required stable funding over a year.
Using gross outflows in the LCR denominator
The word net is overlooked.
Fix: Subtract inflows, capped at 75% of outflows, to get net outflows.
Testing CET1 against 4.5% only and ignoring buffers
Candidates remember the minimum but not the conservation buffer.
Fix: If the question asks about restrictions on distributions, compare CET1 with 4.5% plus 2.5% plus any other stated buffer.

Worked examples

Example 1

Vignette: Northbridge Bank reports the following (in USD millions): common equity including retained earnings 60; goodwill and intangibles 12; Additional Tier 1 instruments 12; Tier 2 instruments 20; risk-weighted assets 600. Assume minimums of 4.5% CET1, 6% Tier 1 and 8% total capital, plus a 2.5% conservation buffer in CET1. Q1: What is the CET1 ratio? Q2: What is the total capital ratio? Q3: By how much does CET1 exceed the level that includes the conservation buffer?

Show the solution

CET1 = 60 − 12 = 48.
Q1: CET1 ratio = 48 ÷ 600 = 8.0%.
Tier 1 = 48 + 12 = 60. Total capital = 60 + 20 = 80.
Q2: Total capital ratio = 80 ÷ 600 = 13.33%.
Q3: Required CET1 with buffer = 4.5% + 2.5% = 7.0%. Excess = 8.0% − 7.0% = 1.0% of RWA = 0.01 × 600 = USD 6 million.

Answer: Q1: 8.0%. Q2: about 13.3%. Q3: CET1 is 1.0 percentage point above 7.0%, which is USD 6 million of capital.

Example 2

Vignette: Harbor Trust reports (in USD millions): Tier 1 capital 60; total exposure 1,500; stock of HQLA after haircuts 84; cash outflows over 30 days 140; cash inflows over 30 days 50; available stable funding 520; required stable funding 500. Assume minimums of 3% leverage ratio and 100% for LCR and NSFR. Q1: What is the leverage ratio? Q2: What is the LCR and does it comply? Q3: What is the NSFR and does it comply?

Show the solution

Q1: Leverage ratio = 60 ÷ 1,500 = 4.0%, which is above 3%.
Q2: Inflows cap = 75% × 140 = 105. Inflows of 50 are below the cap, so net outflows = 140 − 50 = 90.
LCR = 84 ÷ 90 = 93.3%, below 100%. It does not comply.
Q3: NSFR = 520 ÷ 500 = 104%, above 100%. It complies.

Answer: Q1: 4.0%, meets the minimum. Q2: about 93.3%, fails. Q3: 104%, meets the minimum. The bank has adequate leverage and structural funding but a short-term liquidity shortfall.

Exam tips

Write the minimum next to each ratio on your scratch sheet at the start. Most questions then reduce to one division and one comparison.
Always check whether the vignette gives deductions such as goodwill. This is the most common hidden step in the CET1 calculation.
When a question asks why a regulator requires a measure, link it to its purpose: risk-based capital for loss absorption, leverage ratio as a non-risk-weighted backstop, LCR for 30-day stress, NSFR for funding stability.
Read direction words carefully. A higher ratio is safer for all of these measures, so a decline is a weakening unless the vignette says otherwise.
Expect interpretation questions that combine these ratios with asset quality and earnings from a bank analysis, so read the whole exhibit before choosing.

Capital Adequacy and Regulatory Ratios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital Adequacy and Regulatory Ratios: frequently asked questions

What is the difference between Tier 1 and Tier 2 capital?

Tier 1 is the highest-quality capital. It is CET1 (common equity and retained earnings less deductions) plus Additional Tier 1, and it absorbs losses while the bank is still operating. Tier 2 is lower-quality capital, such as long-dated subordinated debt, which absorbs losses mainly when the bank fails.

How do I calculate a bank's capital adequacy ratio?

Add up the relevant regulatory capital and divide by risk-weighted assets. For the total capital ratio the numerator is Tier 1 plus Tier 2. Remember to deduct items like goodwill before you start, and compare the result with the minimum plus any buffers.

What is the difference between LCR and NSFR?

The LCR tests short-term resilience: high-quality liquid assets must cover net cash outflows in a 30-day stress. The NSFR tests structural funding over one year: available stable funding must at least equal required stable funding. Both have a 100% minimum.

Why does the leverage ratio exist if banks already have risk-based ratios?

Risk weights depend on models and assumptions that can understate risk. The leverage ratio divides Tier 1 capital by total exposure without risk weights, so it acts as a simple backstop. The Basel III minimum is 3%.