Capital Adequacy Ratio - Meaning and its Importance

Banks in the modern world face an inherent risk of insolvency. Since the banks are so highly leveraged, there could be a run on the bank any moment if their reserves are considered to be inadequate by the market.

Hence, banks must maintain adequate capital in their vaults if they want to survive. However, what constitutes “adequate” is subjective. This is generally measured in the form of a “capital adequacy ratio” and central banking institutions all over the world prescribe the level of capital that needs to be maintained. In this article, we will have a closer look at the capital adequacy ratio and why it is of paramount importance for banking institutions.

Ensuring Solvency of Banks

The capital adequacy ratio is important from the point of view of solvency of the banks and their protection from untoward events which arise as a result of liquidity risk as well as the credit risk that banks are exposed to in the normal course of their business.

The solvency of banks is not a matter that can be left alone to the banking industry. This is because banks have the savings of the entire economy in their accounts. Hence, if the banking system were to go bankrupt, the entire economy would collapse within no time. Also, if the savings of the common people are lost, the government will have to step in and pay the deposit insurance.

Hence, since the government has a direct stake in the issue, regulatory bodies are involved in the creation and enforcement of capital ratios. In addition to that capital ratios are also influenced by international banking institutions.

Limits The Amount of Credit Creation

Theoretically, reserve requirements are supposed to limit the amount of money that can be created by banking institutions. However, in some countries, like the United Kingdom and Canada, there is no reserve requirement at all. However, here too banks cannot go on creating unlimited money. This is because the capital adequacy ratio also impacts the amount of credit that can be created by the banks.

Capital adequacy ratios mandate that a certain amount of the deposits be kept aside whenever a loan is being made. These deposits are kept aside as provisions to cover up the losses in case the loan goes bad. These provisions therefore limit the amount of deposits that can be loaned out and hence limit creation of credit. Changes to the capital adequacy ratio therefore can have a significant impact on the inflation in the economy.

Credit Exposure

The capital adequacy ratios are laid based on the credit exposure that a particular bank has.

Credit exposure is different from the amount loaned out. This is because banks can have credit exposure if they hold derivative products, even though they have not actually loaned out any money to anybody.

Therefore, the concept of credit exposure and how to measure it in a standardized way across various banks in different regions of the world is an important issue in formulating capital adequacy ratios. There are two major types of credit exposures that banks have to deal with.

  • Balance Sheet Exposure: Balance sheet exposure is the amount of risk that a bank is exposed to on account of the activities that are listed on its balance sheet. This would include the credit exposure that result from the loans that have been sanctioned. It would also result from the credit exposure that is the result of the securities that have been purchased by the bank. Hence an analyst can simply look at the balance sheet and come to an exact estimate of the credit exposure of any bank.

  • Off Balance Sheet Exposure: On the other hand, there are some risky activities that a bank takes that are not listed on the balance sheet. For instance, bank may issue guarantees to some parties on behalf of some other parties. These guarantees are not financial transactions that can be listed on the balance sheet.

    However, they do create credit risk in the process. Similarly the bank may purchase derivative products which do not have any effect on the balance sheet today. However, they may expose the bank to significant amounts of risks. The amounts of catastrophic risks that can be caused by derivatives have been witnessed by the banks during the subprime mortgage crisis.

An analyst therefore needs to measure the credit risk that has been generated by off balance sheet activities. In order to accurately calculate the credit exposure that arises due to such risks, the analyst requires additional information from the banks.

Multi-Tiered Capital

For the purpose of calculating the capital adequacy ratio, not all the bank’s capital is considered to be at an equal footing. The capital is considered to have a multi-tiered structure. Therefore, some part of the capital is considered to be more at risk than other parts. These tiers represent the order in which the banks would write off this capital if the situation to do so arises.

Risk Weighting

Also, all credit exposures of the banks are not considered at an equal footing either. Some of the liabilities of the bank i.e. demand liabilities and the loans that have been financed by them are far more dangerous than other liabilities. Hence, they need to be assigned appropriate risk weights.

Using the system of weighted risks, banks can be more prepared regarding the probability of an adverse outcome and to meet the effects that such an outcome would have on the profitability and solvency of the bank.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.