Capital adequacy

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What is it?

Capital adequacy defines the minimum amount of capital that a bank must hold in proportion to the risks it's taking.

Risks that are taken into account will include credit risk, market risk and operational risk.

Measurements of credit risk will consider how much lending the bank's done - and the chances that it will be paid back. They will also look at which other banks and institutions the bank is trading with - and the chances that it won't be paid for the financial products it's sold on.

Measurements of market risk will look at the danger of the bank losing money if conditions in financial markets change - as a result of commodity prices going through the roof, for example, or the Fed slashing interest rates to the bone.

Measurements of operational risk consider the danger of the bank losing money as a result of failed internal processes, or rogue traders like Jérôme Kerviel.

Capital adequacy is usually given as a percentage. For a particular institution, it is a bank's total capital as a percentage of its total risk weighted assets. Risk weighted assets take into consideration all the categories of risk given above.

The Basel II accord seeks to impose a worldwide total capital adequacy ratio of 8%. It also says that tier one capital should be 4% of a bank's assets.

What's it got to do with the financial crisis?

Since the credit crunch became an issue, capital adequacy has become a big deal. Pre-crunch, it was seen as acceptable for banks to have capital adequacy ratios of as little as 5% based on core tier one capital.

Since the crunch, 5% is considered inadequate. When the UK government launched its bailout of the country's banks in October 2008, it was with the aim of raising their core tier one capital to 8%.

The need for greater capital adequacy has driven banks to raise money through rights issues, overseas investors and government bailouts.

It is also leading banks to deleverage their balance sheets, by cutting back on the amount of loans they've got outstanding. This is where the credit crunch comes: fewer loans mean less credit. And less credit means less liquidity in the economy and slower economic growth.

In March and April 2009, the US government performed "stress tests" to check on the capital positions of many banks. They were found lacking, for the most part, and sent away to raise capital from shareholders. In August and September 2009, financial leaders of the G-20 started to come to terms on worldwide standards for capital adequacy, although leaders of several countries diverged in their views from US Treasury Secretary Timothy Geithner.

Last updated on 7 September 2009.

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