Regulatory Capital: Where Valuation Reaches CET1#
See also
The Basel Framework, including the standard on the definition of capital
PRA Rulebook, for the UK rules
Regulatory capital is the loss-absorbing resource a bank must hold against the risks it takes. The rule is a ratio: the bank’s capital, in tiers according to quality, divided by its risk-weighted assets.
This page covers only the part that valuation control touches. Capital starts from the accounting balance sheet, so the fair values that valuation control signs off flow straight into it, and several adjustments to that balance sheet are driven by valuation.
The tiers of capital#
Tier |
What it is |
Basel III minimum, as a share of RWAs |
|---|---|---|
Common Equity Tier 1 (CET1) |
Ordinary shares and retained earnings, less regulatory deductions. The best quality capital, as it absorbs losses while the bank is a going concern. |
4.5% |
Additional Tier 1 (AT1) |
Perpetual instruments, such as contingent convertible bonds, that convert or are written down when CET1 falls below a trigger. |
Tier 1 in total (CET1 plus AT1) is 6% |
Tier 2 |
Subordinated debt with at least five years to run. It only absorbs losses when the bank fails. |
Total capital (Tier 1 plus Tier 2) is 8% |
On top of these minimums the bank holds buffers and a bank-specific add-on from the supervisor, which are set by the regulator and are not covered here.
Deductions from CET1#
The accounting equity is adjusted before it is counted as CET1. Some of the adjustments depend directly on valuation:
Adjustment |
Why it exists |
|---|---|
Prudent valuation adjustment (AVA) |
Fair value is a best estimate, but capital should not rely on a value that could be wrong in the unfavourable direction. The AVA deducts the valuation uncertainty from CET1. See Prudent Valuation. |
Own credit and DVA |
Gains on the bank’s own credit, including DVA on derivatives, are removed so that a worsening in credit quality does not increase capital. See CVA: Credit Valuation Adjustment. |
Cash flow hedge reserve |
The reserve in other comprehensive income is filtered out, so that capital does not move with the value of hedges of items that are not at fair value. See IFRS 9: Financial Instruments. |
Other deductions, such as goodwill, other intangibles and deferred tax assets that depend on future profits, are not driven by valuation.
Capital and the cost of a trade#
The capital ratio links regulation to pricing. A derivative that consumes capital has a cost, since shareholders require a return on it. That cost is the KVA described in KVA: Capital Valuation Adjustment. The example on that page assumes capital of 10.5% of risk-weighted assets, which is the 8% total capital minimum plus the 2.5% capital conservation buffer. A real calculation would also include the bank-specific add-ons and its own target.
A valuation control view#
Fair value feeds capital: the balance sheet that valuation control controls is the starting point of the CET1 calculation. A valuation error is a capital error.
Deductions: the prudent valuation adjustment and the DVA filter are CET1 deductions that valuation control calculates or reviews.
Data: the same trade, market and reference data feeds the valuation, the exposures and the capital, so one set of controls serves all three. See the tests of timeliness, completeness and accuracy in Governance: Model Risk, Accountability and Data.