Prudential Requirements: Capital, Liquidity, and Governance Explained

What Are Prudential Requirements?

Prudential requirements are the rules banks and financial institutions must follow to stay safe, stable, and able to pay their customers-even during a crisis. Think of them as financial seatbelts. They don’t prevent accidents, but they keep you from getting crushed when things go wrong. These rules didn’t appear out of nowhere. They came after the 2008 financial collapse, when too many banks were operating with almost no cushion against losses. The world realized: if banks fail, the whole economy shakes. So global regulators, led by the Basel Committee on Banking Supervision an international body under the Bank for International Settlements that sets global standards for bank regulation, built a new framework called Basel III a set of international banking regulations introduced after the 2008 financial crisis to strengthen bank capital and liquidity requirements. It’s now the global baseline, adopted in some form by nearly every major economy.

Capital: The Financial Cushion

Capital is the bank’s own money-money it can lose without collapsing. It’s not deposits. It’s not loans. It’s equity, retained earnings, and other high-quality funds that absorb losses. The core requirement under Basel III is the Common Equity Tier 1 (CET1) the highest-quality form of bank capital, primarily consisting of common stock and retained earnings, used to absorb losses ratio. Banks must hold at least 4.5% of their risk-weighted assets as CET1 capital. But that’s just the floor. Add a 2.5% Capital Conservation Buffer an additional capital buffer banks must hold to avoid restrictions on dividends and bonuses during stress periods, and you’re at 7%. For the biggest banks-those considered systemically important-there’s an extra surcharge, up to 3.5%. So a top global bank like JPMorgan Chase might hold a CET1 ratio of 14%, far above the minimum.

Why risk-weighted assets? Not all loans are equal. A mortgage to a homeowner with great credit gets a low weight. A loan to a startup with no profits gets a high weight. The system forces banks to hold more capital against riskier bets. The U.S. uses a tiered system under the Tailoring Rule a U.S. Federal Reserve rule that applies different regulatory requirements based on a bank’s size and risk profile. Banks under $100 billion in assets face lighter rules. Those over $700 billion? They’re under constant stress testing, required to run simulations of economic meltdowns every year.

Liquidity: Cash on Hand When It Counts

Capital protects against losses. Liquidity protects against runs. A bank can be profitable and still fail if it can’t pay out cash when customers withdraw or lenders demand repayment. That’s what happened in 2008-banks had assets, but no cash to move. Basel III fixed that with two ratios.

The first is the Liquidity Coverage Ratio (LCR) a regulatory requirement that banks hold enough high-quality liquid assets to survive 30 days of cash outflows under stress. It requires banks to hold enough cash or easily sold assets-like U.S. Treasury bonds-to cover 30 days of expected withdrawals. The minimum is 100%. Citigroup reported a 129% LCR in 2022. That’s a comfortable buffer.

The second is the Net Stable Funding Ratio (NSFR) a long-term liquidity requirement ensuring banks fund their assets with stable sources like deposits, not short-term borrowing. This one looks further ahead. It forces banks to match the maturity of their loans with stable funding sources. A 10-year mortgage shouldn’t be funded with 30-day repo loans. That’s a recipe for disaster. NSFR requires at least 100% stable funding over a one-year horizon.

These rules hit hardest at smaller banks. According to the American Bankers Association, 68% of banks under $10 billion in assets say capital and liquidity rules are their biggest burden. Compliance costs for them average 1.8% of revenue-double what big banks pay.

Governance: Who’s Really in Charge?

Rules mean nothing if no one follows them. That’s where governance comes in. It’s not about paperwork. It’s about culture, accountability, and leadership. The European Union’s CRD VI the latest EU directive that updates capital requirements and strengthens governance rules for banks and the UK’s Prudential Regulation Authority the UK regulator responsible for prudential oversight of banks, building societies, and major investment firms now demand more than just financial controls. Boards must actively oversee risk. Executives must be held responsible for failures. Compensation structures can’t reward reckless behavior. In 2023, the PRA issued a new supervisory statement requiring senior managers to personally certify their institution’s risk controls.

It’s not just about the board. It’s about internal controls, audit functions, and training. PwC found banks spend an average of 150 hours per employee per year on compliance training. For staff working on capital or liquidity, it’s over 250 hours. New hires take 18 to 24 months to become fully proficient. And documentation? The EU requires 200+ public data points. APRA in Australia mandates detailed plans for every possible liquidity crisis.

When regulators examine midsize U.S. banks, they find problems in 37% of capital planning processes and 28% of liquidity risk controls. That’s not because people are lazy. It’s because the system is complex. One mistake in modeling, one misclassified asset, one overlooked third-party vendor-and you’re in violation.

How Do Different Countries Handle It?

Basel III is global, but implementation isn’t uniform. The EU treats it like a law-CRR III the EU regulation that implements Basel III standards into EU law with specific rules for capital and liquidity and CRD VI the EU directive that updates governance, risk management, and supervisory practices for banks-and adds local tweaks. They give smaller banks breathing room. The U.S. has three regulators-the Federal Reserve, OCC, and FDIC-each with their own rules, though the Tailoring Rule brought more consistency. Australia’s APRA uses a three-pillar system: legally binding standards, non-binding guidelines, and mandatory reporting. The UK’s PRA focuses on leadership failures-poor culture, weak accountability-as much as balance sheet numbers.

Small banks in the U.S. are exempt from stress tests under $100 billion. In the EU, institutions under €30 billion get proportionally lighter rules. But even with exemptions, compliance costs are rising. The Institute of International Finance says compliance for banks between $50-100 billion jumped 27% from 2010 to 2020. And now, with climate risk and crypto assets entering the picture, the rules are getting even more complex.

What’s Changing in 2025?

Prudential requirements aren’t frozen. They’re evolving. In 2023, the EU approved new rules requiring banks to run climate scenario analyses by 2025. The U.S. Federal Reserve proposed similar rules. Climate risk isn’t a future threat-it’s a balance sheet issue. Flooded homes mean defaulted mortgages. Heatwaves mean business closures. Banks must now model these risks into their capital planning.

Crypto is another frontier. The Basel Committee proposed a 1,250% risk weight for certain crypto exposures. That means for every $100 in Bitcoin holdings, a bank must hold $1,250 in capital. It’s a deterrent. Most banks won’t touch it. But some are testing the waters, and regulators are watching.

Non-bank lenders are next. Money market funds, securities lenders, and mortgage servicers are increasingly part of the financial system. The Financial Stability Board is preparing rules for them by 2024. In the U.S., nonbank mortgage servicers have already been squeezed. The number dropped from 227 in 2018 to 153 in 2022 because they couldn’t meet minimum net worth rules. The same pressure is coming for other non-banks.

Who Benefits? Who Struggles?

The system works. Global banks are stronger. The median CET1 ratio for top banks rose from 11.2% in 2010 to 14.7% in 2021. Financial crises are less frequent. The Basel Committee estimates a 31% drop in crisis likelihood.

But the cost is real. Critics like Stanford’s Anat Admati say banks still operate with too little equity-sometimes as low as 3% of total assets if they game the risk weights. The Institute of International Finance warns that compliance costs are squeezing credit to small businesses. And smaller banks? They’re getting squeezed out. The system favors scale. Big banks have teams of lawyers, modelers, and compliance officers. Small banks have one person wearing five hats.

There’s also a hidden effect: less competition. When compliance costs rise, it’s harder for new banks to enter. The market becomes more concentrated. That’s not necessarily bad for stability-but it’s bad for choice.

What Does This Mean for You?

If you’re a customer, it means your bank is safer. Your deposits are less likely to vanish in a crisis. Your loans might be harder to get, especially if you’re a small business-because banks are more cautious. If you’re in finance, you’re dealing with more paperwork, more training, and more pressure. If you’re a regulator, you’re balancing safety with growth. And if you’re watching from the sidelines, remember: prudential requirements aren’t about stopping banks from making money. They’re about making sure they don’t take the whole economy down with them.

How Are These Rules Enforced?

Regulators don’t just write rules-they audit, inspect, and penalize. The U.S. Office of the Comptroller of the Currency (OCC) examines banks regularly. In 2022, they found capital planning flaws in 37% of midsize banks. The UK’s PRA conducts deep dives into governance, looking at board minutes, executive pay, and internal whistleblowing records. APRA in Australia can force a bank to raise capital or stop new lending if it falls short. Non-compliance isn’t a fine. It’s a threat to the bank’s license to operate.

What Happens If a Bank Fails to Meet Requirements?

If a bank’s capital falls below the minimum, regulators step in immediately. They might require a capital raise, block dividend payments, or restrict new lending. If liquidity drops below LCR, they can force asset sales or limit withdrawals. Governance failures? Senior executives can be barred from the industry. In extreme cases, the bank is taken over or liquidated. The goal isn’t punishment-it’s prevention. The system is designed to catch problems before they become crises.