# Understanding Risk-Based Capital Requirements: Definition, Tiers & Calculations

> **Definition**
>
> A risk-based capital requirement is a rule that mandates financial institutions to maintain a minimum level of capital based on their risk profile to ensure stability and protect against insolvency.

## What Is a Risk-Based Capital Requirement?

A risk-based capital requirement sets minimum regulatory capital levels for financial institutions. They ensure financial institutions can withstand [operating losses](https://www.investopedia.com/terms/o/operating-loss.asp) while maintaining a stable market.

In the U.S., risk-based capital requirements were raised by the Dodd-Frank Act following the Great Recession. The Basel Accords set the global standard for risk-based capital reserves.

### Key Takeaways

*   Risk-based capital requirements ensure banks have enough capital to cover operating losses and maintain financial stability.  
    
*   These requirements protect financial institutions, investors, and the economy by preventing insolvency.  
    
*   The Dodd-Frank Act mandates minimum risk-based capital ratios of 8% for total capital and 4.5% for tier 1 capital.  
    
*   Tier 1 capital typically includes common stock, reserves, and retained earnings, with total capital encompassing both tier 1 and tier 2.  
    
*   Basel Accords provide guidelines to assess banks' credit risk related to balance sheet and off-balance sheet exposure.

![Risk-Based Capital Requirement](https://www.investopedia.com/thmb/sobGGxzzcx8EWHldM8vmpyfo0uo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/risk-based-capital-requirement_final-8f003e3dbb5e405b9c8e25c8f85dce96.png)

*— Investopedia / Laura Porter*

## In-Depth Analysis of Risk-Based Capital Requirements

Risk-based capital requirements are now subject to a permanent floor, as per a rule adopted in June 2011 by the [Office of the Comptroller of the Currency](https://www.investopedia.com/terms/o/office-comptroller-currency-occ.asp) (OCC), the Board of Governors of the Federal Reserve System, and the [Federal Deposit Insurance Corporation](https://www.investopedia.com/terms/f/fdic.asp) (FDIC). The rule also offers flexibility in risk calculations for some low-risk assets.

The Collins Amendment of the [Dodd-Frank](https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp) Wall Street Reform and Consumer Protection Act imposes minimum risk-based capital requirements for insured [depository](https://www.investopedia.com/terms/d/depository.asp) institutions, depository institutions, holding firms, and non-bank financial companies that are supervised by the Federal Reserve.

Under the Dodd-Frank rules, each bank is required to have a total risk-based capital ratio of 8% and a tier 1 risk-based capital ratio of 4.5%. A bank is considered "well-capitalized" if it has a tier 1 ratio of 8% or greater and a total risk-based capital ratio of at least 10%, and a tier 1 leverage ratio of at least 5%.

## Key Elements of Tier 1 and Total Capital in Risk Management

Tier 1 capital usually includes common stock, disclosed reserves, retained earnings, and some types of preferred stock. Total capital combines tier 1 and tier 2 capital, representing the difference between assets and liabilities.

To set guidelines on how banks should calculate their capital, the Basel Committee on Banking Supervision, which operates through the [Bank for International Settlements](https://www.investopedia.com/terms/b/bis.asp), publishes the [Basel Accords](https://www.investopedia.com/terms/b/basel_accord.asp). Basel I was introduced in 1988, followed by Basel II in 2004. Basel III was developed in response to deficits in financial regulation that appeared in the late 2000s financial crisis. These guidelines are meant to help assess a bank's credit risk related to its balance sheet assets and off-balance sheet exposure.

## Comparing Risk-Based and Fixed-Capital Standards

Both risk-based and [fixed-capital](https://www.investopedia.com/terms/f/fixed-capital.asp) standards cushion companies from insolvency. Fixed-capital standards require equal reserves for all companies, while risk-based capital varies with risk levels.

The insurance industry began using risk-based capital instead of fixed-capital standards in the 1990s after a string of insurance companies became insolvent in the 1980s and 1990s. For example, in the 1980s, under the fixed-capital standards, two insurers of the same size in the same state were generally required to hold the same amount of capital in reserve, but after the 1990s, those insurers faced different requirements based on their insurance niche and their unique level of risk.