The chain from exposure to capital
Exposure becomes risk-weighted assets through the risk weight. Risk-weighted assets become a capital requirement through the 8% ratio.
RWA = EAD × RWCapital requirement = 8% × RWA
A 100% risk weight therefore costs 8 units of capital per 100 units of exposure. This is the single most misread number in credit risk.
What the 8% is made of
| Layer | Minimum | On RWA of 1,000,000 |
|---|---|---|
| Common equity tier 1 | 4.5% | 45,000 |
| Tier 1 | 6.0% | 60,000 |
| Total capital | 8.0% | 80,000 |
These are Pillar 1 minimums. The capital conservation buffer adds 2.5% of RWA in common equity for most banks, and systemic buffers can add more, so the practical requirement is usually above 8%.
Worked example
Corporate exposure, EAD 10,000,000, IRB risk weight 82.06%.
- RWA: 8,205,940
- Total capital at 8%: 656,475
- Common equity at 4.5%: 369,267
- With a 2.5% conservation buffer: 707,762 total, of which 574,416 must be common equity
Why banks manage RWA, not exposures
Two exposures of the same size can consume capital at a ratio of four to one depending on risk weight. That is why credit risk teams spend their time on PD, LGD, collateral and exposure class rather than on balance sheet size alone. It also explains why a portfolio can grow while capital stays flat, and the reverse.
What the capital requirement is not
- It is not expected loss. Expected loss is PD × LGD × EAD; capital covers unexpected loss.
- It is not a provision. Provisions are accounting; capital is a regulatory buffer.
- It is not the same as the leverage ratio, which ignores risk weights and applies a 3% minimum to total exposure.
- It is not a tax on lending. It is the equity the bank must fund against the risk.
Questions
Is the capital requirement 8% of the exposure?
No. It is 8% of risk-weighted assets, which are exposure times risk weight.
What is the difference between 8% and 10.5%?
8% is the Pillar 1 minimum. Adding the 2.5% capital conservation buffer gives 10.5%, which is the level most banks must hold before distributions are restricted.
Do all exposures carry the same 8%?
The percentage is the same. The risk weight differs, so the capital per unit of exposure differs.