Key Concepts of Capital Adequacy Requirements

Capital adequacy requirements ensure banks have enough capital to handle risks and absorb losses. The Basel III framework, introduced after the 2008 crisis, sets standards for capital levels, enhancing financial stability and risk management in the banking sector.

1. Basel III framework

   • Introduced in response to the 2008 financial crisis to strengthen bank capital requirements.
   • Aims to improve the banking sector's ability to absorb shocks and reduce systemic risk.
   • Focuses on enhancing risk management and governance within financial institutions.

2. Tier 1 and Tier 2 capital

   • Tier 1 capital consists of the most reliable and liquid forms of capital, primarily common equity.
   • Tier 2 capital includes subordinated debt and other instruments that can absorb losses but are less secure than Tier 1.
   • Both tiers are essential for meeting regulatory capital requirements and ensuring financial stability.

3. Risk-weighted assets (RWA)

   • RWA measures a bank's assets, weighted by credit risk, to determine capital adequacy.
   • Higher risk assets require more capital to be held against them, reflecting their potential for loss.
   • RWA calculations help regulators assess the risk profile of financial institutions.

4. Common Equity Tier 1 (CET1) ratio

   • CET1 ratio is the ratio of a bank's core equity capital to its total risk-weighted assets.
   • A higher CET1 ratio indicates a stronger capital position and greater ability to withstand financial stress.
   • Regulatory minimum for CET1 ratio is set at 4.5% under Basel III.

5. Leverage ratio

   • The leverage ratio is a measure of a bank's capital relative to its total exposure, including off-balance-sheet items.
   • It serves as a backstop to the risk-based capital ratios, ensuring banks maintain a minimum level of capital.
   • The minimum leverage ratio requirement is set at 3% under Basel III.

6. Liquidity Coverage Ratio (LCR)

   • LCR requires banks to hold sufficient high-quality liquid assets to cover net cash outflows for 30 days.
   • It aims to ensure that banks can survive short-term liquidity disruptions.
   • The minimum LCR requirement is set at 100%.

7. Net Stable Funding Ratio (NSFR)

   • NSFR measures the stability of a bank's funding over a one-year horizon, promoting longer-term funding.
   • It requires banks to maintain a stable funding profile in relation to their assets and off-balance-sheet activities.
   • The minimum NSFR requirement is set at 100%.

8. Capital conservation buffer

   • This buffer is an additional layer of capital above the minimum capital requirements to absorb losses during periods of financial stress.
   • It is set at 2.5% of risk-weighted assets, promoting capital retention during good times.
   • Banks must maintain this buffer to avoid restrictions on capital distributions.

9. Countercyclical capital buffer

   • This buffer is designed to ensure that banks build up capital during periods of economic growth to be used during downturns.
   • It can be adjusted by regulators based on economic conditions, ranging from 0% to 2.5% of risk-weighted assets.
   • Helps mitigate the procyclical nature of banking and enhances financial stability.

10. Systemically important financial institution (SIFI) requirements

    • SIFIs are subject to additional capital and regulatory requirements due to their size and interconnectedness in the financial system.
    • These requirements include higher capital ratios and enhanced supervisory measures.
    • The goal is to reduce the risk of failure of these institutions and their potential impact on the global economy.