Capital Adequacy
What is Capital Adequacy?
Capital adequacy is the rule that a bank must fund itself with enough loss-absorbing capital, mostly equity, in proportion to the riskiness of its assets.
A bank funds long, risky assets with short liabilities that depositors expect back at par, so the question regulators ask is how much of that funding is equity which can be written down without the bank failing. Capital adequacy answers it as a ratio of capital to risk-weighted assets, where each asset is multiplied by a weight meant to reflect its credit risk, so a high-grade government bond can carry a zero weight while an unrated corporate loan is weighted at or near 100 percent. Under the Basel framework banks must hold total capital of at least 8 percent of risk-weighted assets, including common equity tier 1 of at least 4.5 percent, plus a conservation buffer of a further 2.5 percent of common equity that restricts payouts once it is breached. Because this is a fraction, a bank under pressure can meet it either by raising capital or by shrinking and derisking its assets, and the second route is faster, which is how tightening capital rules in a downturn can cut off lending. The weights are also only as good as the risk model behind them, so assets the rules treat as safe can pile up in large amounts, which is why the framework adds a simple leverage ratio of tier 1 capital to total unweighted exposure as a backstop.
Capital Adequacy: a worked example
A bank holds $200 million of government bonds weighted at 0 percent, $300 million of residential mortgages weighted at 50 percent and $500 million of corporate loans weighted at 100 percent. Risk-weighted assets are 0 + 150 + 500 = $650 million, against $1 billion of actual assets. With $52 million of capital the ratio is 52 ÷ 650 = 8.0 percent, which just meets the 8 percent minimum, and the leverage ratio of $52 million against $1 billion of exposure is 5.2 percent, above the 3 percent floor. Now suppose the bank swaps its government bonds for corporate loans: risk-weighted assets rise to $850 million and the ratio falls to 52 ÷ 850 = 6.1 percent. Total assets have not changed at all, but the requirement is now 0.08 × 850 = $68 million, so the bank must raise $16 million of new capital or sell $200 million of corporate loans.
The mistake students make with capital adequacy
Students divide capital by total assets instead of risk-weighted assets and conclude that a bank stuffed with government bonds is thinly capitalized. The denominator is weighted, so the same $1 billion balance sheet produces very different requirements depending on what is in it. The larger misconception is picturing capital as a pile of cash sitting in a vault. Capital is a funding source on the liabilities side, not an asset: it is the share of the bank's assets financed by shareholders rather than by depositors and lenders, and cash reserves are a separate requirement entirely.
Capital Adequacy questions
What is the difference between capital requirements and reserve requirements?
Capital requirements are about solvency and sit on the funding side of the balance sheet: they set how much of a bank's assets must be financed by shareholders instead of creditors. Reserve requirements, where they still apply, are about liquidity and sit on the asset side: they set how much must be held as cash or as deposits at the central bank. A bank can satisfy one and fail the other, because they answer different questions.
Why are bank assets risk-weighted instead of simply added up?
A flat ratio on total assets would demand the same capital against a short-term government bond as against an unsecured loan to a new firm, which pushes banks toward the riskiest assets available for a given balance sheet size. Weighting is meant to make the capital charge track the actual chance of loss. The cost is complexity and gaming, since a bank that influences its own risk model can lower its requirement without lowering its risk, which is why an unweighted leverage ratio runs alongside the weighted one.
What happens if a bank falls below its capital requirement?
Well before insolvency, breaching the conservation buffer triggers automatic limits on dividends, buybacks and bonuses, which forces retained earnings back into capital. Falling below the hard minimum brings supervisory intervention, from a mandatory capital restoration plan to restrictions on new business, and ultimately resolution, in which shareholders are wiped out and some creditors are converted into equity. The escalating ladder is deliberate, since correction is far cheaper while the bank still has value.
Formula / Example
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