Capital adequacy

Central banks impose capital adequacy ratios (also known as solvency ratios) that set the amount of its own money a bank needs to have relative to its total loan portfolio.

A bank needs to have enough money on hand to cover any losses it might make if any of the groups or individuals it has lent money defaults on their loans. If it does not, it may find itself unable to cover what it owes to its depositors, and hence become insolvent.

Central banks do not allow commercial banks to decide for themselves how much to keep to cover the risk. Instead, they impose capital adequacy ratios (also known as solvency ratios) that set the amount of its own money a bank needs relative to its total loan portfolio.

The Basel Accord requires all banks to maintain primary capital equal to at least 8% of their assets (ie have a capital adequacy ratio of at least 8%). Individual central banks may require higher levels of capital adequacy in their own areas of jurisdiction.

Also, different kinds of banks will have different ratios. For instance, loans to small businesses tend to be defaulted more frequently than mortgages on residential property, so banks with a high level of exposure to the former may want to have a higher capital adequacy ratio, as would banks with, for example, a high exposure to derivatives.

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
Interest rates might rise faster than expected – what does that mean for your money?
Global Economy

Interest rates might rise faster than expected – what does that mean for your money?

The idea that the US Federal Reserve could raise interest rates much earlier than anticipated has upset the markets. John Stepek explains why, and wha…
6 Jan 2022