Percentage ratio of a financial institution’s primary capital to its assets (loans and investments), used as a measure of its financial strength and stability. According to the Capital Adequacy Standard set by Bank for International Settlements (BIS), banks must have a primary capital base.
Regulators
try to ensure that banks and other financial institutions have sufficient
capital to keep them out of difficulty. This not only protects depositors, but
also the wider economy, because the failure of a big bank has extensive
knock-on effects.
The
risk of knock-on effects that have repercussions at the level of the entire
financial sector is called systemic risk.
Capital adequacy requirements
have existed for a
long time, but the two
most important are
those specified by the Basel committee of the Bank for International
Settlements.
This
new capital framework consists of three pillars: minimum capital requirements,
a supervisory review process, and effective use of market discipline. With
regard to minimum capital requirements, the Committee recognizes that a
modified version of the existing Accord should remain the
"standardized" approach, but that for
some sophisticated banks
use of internal
credit ratings and,
at a later
stage, portfolio models
could contribute to a more accurate assessment of a bank's capital
requirement in relation to its particular risk profile. It is also proposed
that the Accord's scope of application be extended, so that it fully captures
the risks in a banking group.