capitaladequacy

Capital adequacy is a measure of a bank's capital in relation to its risk exposure, used to assess its ability to absorb losses and continue operating during periods of financial stress. Regulators require banks to hold a minimum amount of capital relative to their risk-weighted assets (RWAs) to promote solvency, protect depositors, and support financial stability. Capital adequacy frameworks distinguish between the quality and quantity of capital.

Bank capital is tiered: Common Equity Tier 1 (CET1) is the highest quality, typically consisting of common shares and retained earnings. Additional Tier 1 (AT1) instruments are perpetual or long-term but subordinate. Tier 2 capital includes supplementary capital such as subordinated debt. The capital adequacy ratio (CAR) is a regulatory measure defined as capital (often total regulatory capital, i.e., CET1 + AT1 + Tier 2) divided by risk-weighted assets. Banks also report CET1 ratios, which use only CET1 capital divided by RWAs.

Under Basel III, minimum requirements were tightened. A CET1 ratio of 4.5% of RWAs is required, and total capital ratio of 8% is required. A capital conservation buffer of 2.5% increases the effective CET1 requirement to 7% of RWAs. National authorities may impose a countercyclical capital buffer up to 2.5% during periods of excessive credit growth. Additional national buffers and various risk-based rules may apply; some jurisdictions also apply a non-risk-weighted leverage ratio as a backstop.

Regulators supervise banks to ensure compliance and may require remedial actions if capital falls short. The framework aims to align incentives, limit excessive risk-taking, and enhance confidence in the banking system.