Capital adequacy

Capital Adequacy is a term used in the field of financial regulation to describe the minimum amount of capital that a bank or other financial institution must hold as required by its financial regulator. This is usually defined as a bank's capital divided by its risk-weighted assets.

Overview

Capital adequacy ratios (CARs) are a measure of the amount of a bank's capital expressed as a percentage of its risk-weighted credit exposures. This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.

Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Calculation

The risk-weighted assets take into account credit risk, market risk and operational risk. The Basel III accord stipulates that banks must have a tier 1 capital ratio of 6% and a total capital ratio of 8%.

Importance

Capital adequacy ratios are a critical measure of the health of a bank. They are used to protect depositors from the risk that a bank might become insolvent. The higher the CAR, the better equipped the bank is to handle losses without becoming insolvent.

See also

• Basel Accords
• Bank regulation
• Financial stability
• Risk management