Capital Adequacy: What is it and why is it important?
Regulators endeavour to ensure that financial institutions, banks and investment firms have enough capital to ensure their businesses remain stable. This measure not only protects depositors within the industry but also the larger economy as failures of institutions, such as banks, can have wider-scale repercussions.
Capital Adequacy aka Regulatory Capital Requirement
‘Capital Adequacy’ is therefore the statutory minimum capital reserve that a financial institution or investment firm must have available and regulatory capital adequacy provisions thus require relevant firms to maintain these minimum levels of capital, calculated as a percentage of its risk weighted assets. Often Capital Adequacy is referred to as the required Regulatory Capital of a firm.
What does ‘capital’ mean in this circumstance?
Here, ‘capital’refers to what is a bolster of cash, reserves, equity and subordinated liabilities available to a firm so that it is able to absorb losses during periods of financial strain, and is often referred to as ‘own funds’.
This bolster may consist of layers (or ‘tiers’) of capital, with each layer displaying varying degrees of permanence, subordination and flexibility of distributions.
What are the Capital Adequacy Requirements in the UK?
In Europe, the capital adequacy requirements for those firms in the financial sector are specified by the Basel committee and the Bank for International Settlements as enforced by the UK regulators, the FCA and the PRA.