Foundations · F12 · 10 min

Regulation and market plumbing

Work out a toy bank’s capital and liquidity ratios, and know the benchmark and settlement changes that shape trading.

In the news: Bank collapses, the end of LIBOR and faster settlement: the rules behind the stories.

The essentials

Capital and CET1: Capital is a bank’s own money, which takes losses before depositors do. The core measure is , mostly shareholders’ equity: a bank with £5bn of it can lose £5bn before depositors are at risk.
Risk-weighted assets: Each asset is scaled by a risk weight: in a simple example, 0% for , 35% for mortgages and 100% for company loans. £5bn of CET1 against £25.5bn of is a 19.6% CET1 ratio.
Leverage ratio: A backstop that ignores risk weights, so government bonds count in full: £5bn of capital on £65bn of total assets is 7.7%. Swapping gilts for loans cuts the CET1 ratio but leaves this unchanged.
Liquidity coverage ratio (LCR): A rule that a bank holds enough liquid assets, such as government bonds, to cover 30 days of stressed outflows: at least 100%. Capital covers losses and liquidity covers runs; Silicon Valley Bank ran out of liquidity first in 2023.
From LIBOR to SONIA: rested on banks’ estimates, which were gamed. Markets moved to rates built from real overnight trades: in sterling, in dollars. Every LIBOR setting had stopped by the end of September 2024.
Settlement cycle: The business days from the trade date (T) to settlement. US shares moved to T+1 on 28 May 2024; the UK and the EU plan to follow on 11 October 2027.

Toy bank ratios

CET1 ratio = CET1 ÷ RWA; leverage ratio = capital ÷ total assets

CET1: core capital: mostly shareholders’ equity
RWA: risk-weighted assets: each asset scaled by its risk weight, then added up

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How it works

1. Why banks are regulated

Banks lend out most of the money savers deposit. If too many loans go bad, or too many savers want their money back at once, a bank can fail and drag others down with it. So rules make banks hold enough of their own money, and enough assets they can turn into cash quickly.

2. Capital absorbs losses

A bank’s capital is its own money: shareholders’ funds that take losses before depositors do. The core measure is capital, mostly shareholders’ equity. A bank with £5bn of CET1 can lose up to £5bn before depositors are at risk.

3. Risk-weighted assets

Safer assets need less capital. Each asset is scaled by a risk weight: in a simple example, 0% for its own government’s bonds, 35% for mortgages and 100% for company loans. The total is the bank’s : £30bn of mortgages at 35% count as £10.5bn.

4. The CET1 ratio

Divide capital by risk-weighted assets to get the CET1 ratio. A bank with £5bn of CET1 and £25.5bn of risk-weighted assets has a ratio of 19.6%. Regulators set a minimum, with extra buffers for the biggest banks.

5. A backstop with no weights

Risk weights can be wrong, so there is a second test that ignores them: the , capital ÷ total assets. £5bn of capital on £65bn of assets is 7.7%. Here, government bonds count in full.

6. Liquidity: surviving a run

A bank can have plenty of capital and still fail if savers all want cash today. The asks whether it could cover 30 days of heavy withdrawals from assets it can sell quickly, such as government bonds. £20bn of such assets against £12bn of likely outflows is 167%; it must be at least 100%.

7. SVB, 2023

In March 2023 Silicon Valley Bank’s depositors, most of them above the insured limit, pulled out over $40bn in a single day. The bank had put deposits into long-dated bonds that lost value as interest rates rose. When it tried to raise money, depositors ran: liquidity ran out before capital did.

8. From LIBOR to SONIA

Loans and swaps used to pay interest set by , based on banks’ own estimates of what they could borrow at. Estimates can be gamed, and were. Markets moved to rates built from real overnight trades: in sterling and SOFR in dollars. Every LIBOR setting had stopped by the end of September 2024.

9. Settling trades: T+1

When you buy shares, the cash and the shares change hands a little later. That delay is the , counted in business days after the trade day (T). US shares moved to T+1 on 28 May 2024; the UK and the EU plan to follow on 11 October 2027. Weekends and holidays don’t count.

Worked example

A toy bank has £5bn of capital, all CET1. It holds £20bn of gilts (0% risk weight), £30bn of mortgages (35%) and £15bn of company loans (100%). Its gilts are its liquid assets, and 20% of its £60bn of deposits could leave in a 30-day stress. (Illustrative weights.)

Risk-weighted assets = £0 + £10.5bn + £15bn = £25.5bn.
CET1 ratio = £5bn ÷ £25.5bn = 19.6%.
Leverage ratio = £5bn ÷ £65bn = 7.7%.
LCR = £20bn ÷ (20% × £60bn = £12bn) = 167%.
Swap £10bn of gilts for loans: risk-weighted assets rise to £35.5bn and the CET1 ratio falls to 14.1%; the leverage ratio stays 7.7%.

CET1 ratio 19.6%, leverage ratio 7.7%, LCR 167%; switching gilts into loans cuts the CET1 ratio but not the leverage ratio.

Check yourself

9 quick questions on the explanation above.

Practice

New numbers every set. Misses and guesses go into your review deck.

In the interview

Answer out loud in under a minute, then compare.

What did SVB’s failure reveal about interest-rate risk at banks?
Why did regulators replace LIBOR, and what replaced it in sterling?
How do capital rules shape what a trading desk is willing to hold?

Remember

CET1 ratio = CET1 ÷ risk-weighted assets

Capital absorbs losses and liquidity survives runs; a bank needs both, as Silicon Valley Bank’s collapse in 2023 showed.

Sources

Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.