What financial markets do and the functions of money; commercial against investment banks; a bank’s balance sheet, the liquidity–profitability trade-off, credit creation, and why capital is the number regulators watch.
After 2008, when RBS and Lloyds needed £65bn of public capital and Northern Rock suffered the first British bank run in 140 years, regulators rewrote the rules on how much of their own money banks must hold against their lending. The final instalment, Basel 3.1, was due in 2025, delayed to 2026, then on 17 January 2025 delayed again to 1 January 2027 while the United States hesitated. On 20 January 2026 the Prudential Regulation Authority published the final rules and confirmed the 2027 date. The PRA has said the overall level of capital in the system, with core capital around 13% of risk-weighted assets, is about right, and is now simplifying the framework for smaller banks.
What do banks and financial markets do, what does a bank’s balance sheet look like, and why is capital the number that matters?
Source: PRA, PS1/26 Implementation of Basel 3.1: final rules, 20 January 2026; PRA announcement, 17 January 2025.
Money is anything generally accepted in payment. It has four functions: a medium of exchange, a store of value, a unit of account and a standard of deferred payment. Notes and coins are a small part of it; most money is bank deposits, created when banks lend. Financial markets channel funds from savers to borrowers and let risk be priced and traded: the money market for short-term lending between banks, the bond market for government and corporate borrowing, the equity market for shares, foreign exchange, and forward and futures markets that let firms fix prices in advance. They facilitate saving, lend to firms and households, run the payments system and allow the exchange of goods and services.
Commercial (retail) banks take deposits, make loans and run payments; they make money on the gap between the interest they pay and the interest they charge. Investment banks help companies and governments issue shares and bonds, advise on mergers, and trade securities for clients and themselves. Many banks do both; since 2019 UK banks with more than £25bn of deposits must ring-fence their retail arms from their investment banking.
A bank’s balance sheet lists its assets (cash and reserves, liquid securities, loans) and its liabilities (deposits, borrowing) with capital as the difference. The liquidity ratio is liquid assets as a share of the total; the capital ratio is capital as a share of assets, usually risk-weighted. Banks face a permanent trade-off: liquid assets are safe but earn little; loans earn more but cannot be sold quickly.
On 1 January 2027 new rules come into force setting how much capital every UK bank must hold.
The rules, Basel 3.1, were agreed internationally after the 2008 crisis. The UK delayed them twice, the second time in January 2025 after the United States slowed its own version, before fixing the date in January 2026.
What is bank “capital”, and why do regulators care so much about it?
Capital is the gap between what a bank owns and what it owes. If loans go bad, capital takes the hit; if it runs out, the bank is insolvent and depositors or taxpayers pay. Northern Rock and RBS had too little. This lesson builds the balance sheet that shows why.
The assets side: what the bank owns or is owed. Cash and reserves at the Bank of England (10) and gilts (15) are liquid: usable at once. Loans and mortgages (70) are where the money is made, and the bank cannot call them in; a 25-year mortgage pays back over 25 years. Buildings and systems (5) are the rest. Total: £100bn.
Check: Which of these is an asset of a commercial bank?
A loan is money the bank is owed: an asset. Deposits and bonds issued are money the bank owes: liabilities. Capital is the difference.
The liabilities side: what the bank owes. Deposits (80) can be withdrawn on demand. Wholesale borrowing (12) is money raised from other banks and markets, often for days or weeks. Capital (8) is the shareholders’ money: assets minus liabilities. Capital is not cash in a vault; it is the slice of the assets that belongs to the owners, and it is what stands between a loss and a failure.
Check: The bank has £100bn of assets, £80bn of deposits and £12bn of wholesale borrowing. Its capital is:
Capital = assets − liabilities = 100 − 92 = 8. It is the shareholders’ stake and the buffer that absorbs losses.
The trade-off. Reserves and gilts can be turned into cash today but earn little; loans earn 5 or 6% but are locked away for years. A bank that holds 25% in liquid assets is safer than one holding 10%, and less profitable. Shareholders push for more loans; regulators, and the memory of queues outside Northern Rock, push the other way. The liquidity ratio is where the two meet.
Teacher tip: Northern Rock in 2007 is the liquidity story: good loans, but funded by short-term wholesale borrowing that stopped overnight. RBS in 2008 is the capital story: losses that exceeded its thin equity. Keep the two failures distinct and students will keep liquidity and solvency distinct.
Check: A bank that wanted to raise its profits would most likely:
Loans earn far more than reserves and gilts; the price is less ability to meet withdrawals. That is the liquidity–profitability trade-off.
Where money comes from. When a bank makes a loan it credits the borrower’s account: a new deposit, new money. The borrower spends it, the recipient deposits it, that bank lends most of it on. With a reserve ratio of 10% the credit multiplier is 10. In practice banks are limited less by reserves than by capital, by the demand for loans, and by Bank Rate, which sets the cost of the reserves they need.
Check: Banks keep 10% of deposits as reserves and lend the rest. A new deposit of £100m can eventually support extra deposits across the banking system of up to:
The credit multiplier is 1 ÷ the reserve ratio. Lending creates deposits: that is how most money comes into existence.
Why regulators watch capital. £5bn of bad loans shrinks the assets; depositors and lenders are still owed the same, so capital takes the whole loss: 8 to 3. Another £5bn would leave the bank owing more than it owns, and the state must choose between letting depositors lose and a rescue. Basel 3.1 standardises the capital banks must hold against each kind of loan from January 2027.
Check: £5bn of the bank’s loans go bad. Its capital falls from £8bn to £3bn, a ratio of 3%. The danger is that:
Capital is the only buffer between loan losses and the people the bank owes. This is why Basel sets minimum capital ratios.
The other way to die. A run: depositors want £40bn now, liquid assets are £25bn, and £70bn of loans cannot be sold in a week. The bank is solvent and illiquid. That is what the lender of last resort is for: the Bank lends cash against the good loans. Banks must now hold a liquidity coverage ratio of liquid assets for 30 days of outflows, and deposit insurance up to £120,000 removes the reason to queue.
Check: Depositors withdraw £40bn in a week. The bank is solvent, with assets worth more than its liabilities, but it still fails. Why?
A run turns long-term assets against on-demand liabilities. The central bank lends against the good loans so the bank can pay out; Northern Rock asked too late and publicly.
Capital is not an asset and it is not cash in a vault. It is the difference between assets and liabilities: the owners’ claim on the assets. Put it on the liabilities side, where it balances the sheet.
Evaluate the view that requiring banks to hold more capital makes the economy safer at little cost.
Bank capital is the difference between a bank’s assets and its liabilities: the shareholders’ stake, and the buffer that absorbs losses before depositors, other lenders or taxpayers lose anything. A bank with £100bn of assets, £92bn of deposits and borrowing and £8bn of capital can lose £8bn on its loans and still pay everyone it owes; a bank with £3bn cannot.
The case for requiring more of it is the experience of 2008. Banks had expanded their lending on thin slices of equity, so losses that would have been survivable with more capital became insolvencies: RBS and Lloyds needed £65bn of public money, and the recession that followed cost far more. Higher capital ratios mean losses fall on shareholders rather than the state, reduce the incentive to gamble that comes from being too big to fail, and make banks less likely to cut lending sharply in a downturn because they have room to absorb losses. The Basel 3.1 rules that take effect in January 2027 standardise how much capital must be held against each kind of loan, and the PRA judges the system’s core capital of around 13% of risk-weighted assets to be about right.
**However,** capital is not free. Equity is more expensive to raise than deposits, so higher requirements raise the cost of lending and can reduce the supply of credit, which is why banks lobby against them and why the UK delayed Basel 3.1 twice while the United States hesitated. Lending may migrate to less-regulated shadow banks, moving risk rather than removing it. And capital addresses insolvency, not illiquidity: Northern Rock in 2007 and Silicon Valley Bank in 2023 met their capital requirements and failed when funding left faster than assets could be sold. Safety also needs liquidity rules, deposit insurance, a lender of last resort and supervision, each with its own cost in moral hazard.
On balance, higher capital has made the system markedly safer at a cost that is real but modest: the evidence since 2008 is that better-capitalised banks lent more steadily through the pandemic and the 2022 gilt crisis, not less. The view is right up to a point; beyond the current levels the returns to further capital diminish, and the next crisis is more likely to come from liquidity or from outside the regulated banks than from too little equity inside them.
Regulatory facts: Prudential Regulation Authority, PS1/26 Implementation of Basel 3.1: final rules, 20 January 2026 (go-live 1 January 2027); PRA announcement of the delay, 17 January 2025. The bank on the diagram is invented, with a balance sheet of £100bn. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.