Capital Adequacy Ratio
The capital adequacy ratio is a measure of a bank's capital relative to its risk-weighted assets, used by regulators to ensure that banks have sufficient capital to absorb losses. It is a central element of prudential regulation and of the international standards known as the Basel framework.
Definition and Components
The capital adequacy ratio is calculated as the ratio of a bank's regulatory capital to its risk-weighted assets, expressed as a percentage. Regulatory capital is divided into tiers, with common equity tier one capital, comprising ordinary shares and retained earnings, being the highest quality and most loss-absorbing.
Risk-weighted assets are computed by assigning weights to different categories of assets according to their credit risk, and by applying charges for market and operational risk. The weighting reflects the riskiness of the assets, so that safer assets require less capital than riskier ones.
Basel Standards
The Basel framework, developed by the Basel Committee on Banking Supervision, sets international standards for capital adequacy. The framework has evolved through successive accords, with Basel III raising the quality and quantity of capital and introducing additional requirements, including buffers and leverage ratios.
The standards require banks to meet minimum ratios, including a minimum common equity tier one ratio, a total capital ratio, and buffers that can be drawn down in stress. The framework also includes requirements for liquidity and for the resolution of failing banks, forming a comprehensive approach to prudential regulation.
Purpose
The purpose of capital requirements is to ensure that banks can absorb losses without becoming insolvent and without disrupting the financial system. Capital provides a buffer that absorbs losses, protecting depositors and creditors and reducing the risk of bank failure and of contagion.
Capital requirements also create incentives for banks to manage risk, since riskier assets require more capital and therefore reduce the return on equity. The design of the requirements seeks to balance the benefits of stability against the costs of reduced lending and of higher funding costs.
Debates
The appropriate level of capital requirements is debated. Proponents of higher requirements argue that they reduce the probability and cost of crises, and that the benefits exceed the costs. Critics argue that higher requirements raise the cost of credit, reduce lending, and may drive activity into less regulated parts of the financial system.
The design of the framework, including the treatment of risk weights and the use of internal models, is also debated. The recognition of the limits of risk-weighted approaches has motivated the introduction of leverage ratios and of stress testing, which provide complementary perspectives on the resilience of banks.
Risk Weights and Internal Models
The calculation of risk-weighted assets relies on weights assigned to different categories of assets. Under the standardised approach, the weights are set by the regulator. Under the internal ratings-based approach, banks use their own models to estimate the risk of their exposures, subject to supervisory approval.
The use of internal models has been criticised for its complexity and for the potential for understatement of risk. The variation in risk weights across banks for similar exposures has raised concerns about comparability, and it has motivated efforts to constrain the use of internal models and to introduce floors.
The Leverage Ratio
The leverage ratio is a supplementary capital requirement that limits the ratio of a bank's capital to its total assets, without risk weighting. It provides a backstop against the understatement of risk and constrains the build-up of leverage.
The introduction of the leverage ratio reflects the recognition that risk-weighted measures may not capture all sources of risk and that excessive leverage contributed to the global financial crisis. The ratio complements the risk-based requirements, providing a simpler measure of resilience.
Stress Testing
Stress testing assesses the resilience of banks to adverse scenarios, examining the effects of the scenarios on capital and on the ability to absorb losses. The results inform the assessment of capital adequacy and the design of supervisory measures.
Stress testing has become a central element of prudential supervision, providing supervisors with information about the resilience of institutions and giving institutions an incentive to manage their risks. The design of scenarios and the treatment of the results affect the effectiveness of the exercise.
Macroprudential Perspective
From a macroprudential perspective, capital requirements are calibrated to address the resilience of the financial system as a whole, not only of individual institutions. The framework includes countercyclical buffers, which are built up in booms and released in downturns, and buffers for systemically important institutions.
The macroprudential approach reflects the recognition that the stability of the system depends on the interaction of institutions and on the build-up of system-wide risks. The calibration of the requirements and the use of the buffers are central to the effectiveness of the framework.