Capital Adequacy

Capital adequacy is a measure of a financial institution's ability to absorb potential losses resulting from various risks to which it is exposed. Financial institutions are required to maintain a certain minimum amount of capital in order to ensure their soundness and the stability of the financial system as a whole. Capital adequacy concerns led to tumbling stock prices of many of the world's largest financial institutions in 2008.

The Basel Committee on Banking Supervision establishes standards for the calculation of minimum capital. The current set of standards was initially published in 2004 and is known as the Basel II Framework. The Framework aims to minimize the difference between regulatory and economic capital. Two types of capital are measured—tier I and tier II capital, with tier I being the most reliable form of capital and consisting primarily of shareholders' equity. Tier II capital is limited to 100 percent of tier I capital. The minimum capital adequacy ratio is 8 percent of the risk-weighted assets. Total capital that banks are required to set aside should cover for three types of risk: credit, market, and operational.

Credit risk is defined as the risk of losses arising from a borrower's nonpayment on its obligations. The Basel II Framework permits banks a choice between two broad methodologies for calculating credit risk: Standardized or Internal Rating-Based, or IRB. Standardized methodology relies on external credit risk assessment by the major rating agencies, whereas the IRB approach uses credit risks systems developed internally by banks, and requires explicit approval of the bank's supervisor. Such approval is subject to certain minimum conditions and disclosure requirements. Under the IRB approach, banks can use their own estimates of risk components that include measures of the probability of default, loss-given default, the exposure at default, and effective maturity.

The IRB methodology is further subdivided into two approaches: foundation and advanced. Under the foundation approach, financial institutions can use their own probability of default and rely on supervisory estimates of other components. Under the advanced approach, banks can also use their own estimates of other risk components.

Market risk refers to the risk of losses that arise from movements in market prices and the resulting decrease in the value of investments. For measuring market risks, banks can use two main valuation methodologies: marking-to-market and marking-to-model. Marking-to-market represents at least daily valuations of positions at current market prices for the same or similar instruments. It means that a security is recorded at its market value rather than book value. The Framework encourages banks to mark-to-market as much as possible. Where it is not feasible, however, banks are allowed to use marking-to-model, which is defined as any valuation that needs to be extrapolated or otherwise calculated based on financial models. Just as with credit risk, for calculating capital requirements for market risks, banks can use either the Standardized methodology that relies on external assessment, or the Internal Measurement approach. Banks that rely on internal models are required to have in place a comprehensive stress-testing system.

Operational risk is defined as the risk of loss resulting from faulty internal processes, from human mistakes or systems failures, or from external events. Legal risks are included in the notion of the operational risk, but strategic and reputational risks are not. For operational risk there are three methods of calculation, listed in order of increased sophistication and risk sensitivity: the Basic Indicator approach, the Standardized approach, and the Advanced Measurement approach. Banks using the Basic Indicator approach must hold capital equal to the average over the previous three years of a certain percentage of positive annual gross income. In the Standardized approach, banks' activities are divided into eight business lines, and the capital requirement for each line is calculated by multiplying gross income by a factor assigned to that business line. Under the Advanced Measurement approach, banks develop increasingly risk-sensitive operational risk allocation techniques.

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