Regulatory Capital
Regulatory capital is the loss-absorbing funding a financial firm must hold by law — for a bank, common equity and certain subordinated instruments measured against risk-weighted assets; for a payment or e-money institution, own funds measured against its volume or float. It caps how fast a regulated business can grow and shapes what an acquirer pays, because goodwill from a purchase is deducted from it.
- Also known as
- Own funds, Capital requirements, CET1
- Used at
- every bank's balance sheet, every licensed payment and e-money institution, and the pricing of any acquisition of one
- Binding
- yes — a breach triggers supervisory action, restrictions on dividends and, at the limit, resolution
- Typical minimums
- under Basel III a bank holds common equity tier 1 (CET1) of at least 4.5% of risk-weighted assets plus a 2.5% conservation buffer — 7% before any firm-specific add-on; total capital of 8% plus buffers. An EU e-money institution holds own funds of at least 2% of its average outstanding e-money
- Typical deal effect
- goodwill and most intangibles are deducted from CET1, so a bank paying above tangible book value spends capital, not just cash
- Parties
- the firm, its prudential regulator (the PRA, the ECB, the OCC and Fed, a national authority), and its shareholders, who supply the capital
How regulatory capital works in practice
A bank's assets are weighted by risk — a mortgage counts for less than an unsecured SME loan, a government bond for almost nothing — and the sum is risk-weighted assets. Capital ratios are capital divided by that sum. The minimums are the floor; supervisors add firm-specific requirements and buffers on top, and a bank that runs near its requirement loses the freedom to pay dividends and, in practice, the trust of its counterparties. So growth in lending is growth in RWAs, which needs capital, which comes from retained profit or from shareholders.
For non-bank fintechs the arithmetic is simpler and the effect the same. An e-money institution's own funds scale with the money it holds for customers; a payment institution's with its payment volume. A fintech doubling its float doubles its requirement.
In an acquisition the deduction rule is the one that surprises. If a bank pays €300m for a business with €200m of tangible equity, the €100m of goodwill is deducted from the buyer's CET1: the buyer has spent €300m of cash and €100m of capital, and must either hold more or lend less. That is why bank deals are priced on tangible book value and measured by the years it takes to earn the dilution back — and why a fintech acquirer without a banking licence can sometimes pay more for a lender than a bank can.
Example
A bank with €10bn of risk-weighted assets and a 12% CET1 ratio holds €1.2bn of CET1 against a requirement, with buffers, of 10.5% — €150m of headroom. It buys a consumer lender for €400m; the lender has €250m of tangible equity and €1.8bn of RWAs. After the deal the bank's RWAs are €11.8bn, requiring €1.24bn at 10.5%. Paying cash, it does not add the lender's equity to its own: on consolidation that equity is replaced by the lender's assets and €150m of goodwill, and goodwill is deducted from CET1. Its CET1 falls to €1.05bn, a ratio of 8.9% — below its requirement. The bank has to raise at least €190m of equity alongside the deal, or €366m to keep its ratio at 12% — a cost the acquisition case has to carry, and one a non-bank buyer would not.
Common mistakes
- Modelling an acquisition on cash and forgetting the goodwill deduction from capital. - Growing a lending book faster than retained earnings can capitalise it, then discovering the next round is a rescue. - Treating the minimum as the target; supervisors and counterparties price the buffer. - For a fintech, holding own funds at the requirement while the float grows monthly. - Assuming the regulator's capital view of a deal matches the accountant's; it rarely does.