Capital Adequacy

Capital is the loss-absorbing cushion made up mainly of shareholders' equity and retained profit. The test compares the amount of that cushion with the size of risks being run. For banks the main measure divides capital by risk-weighted assets, where riskier assets count for more. Regulators set a minimum ratio, add buffers on top, and may add firm-specific demands after review. A separate backstop ratio ignores risk weights as a safeguard against model error. Insurers have their own solvency regimes with similar logic. Firms also form their own view of how much they need through internal processes, which can be higher than the regulatory floor. Capital requirements are the rules that apply, while adequacy is the question of whether the actual amount meets them. Slipping below the requirement costs a bank its freedom first, through limits on dividends and bonuses, and brings supervisory intervention if the shortfall persists.

Twelve units of capital stand against 100 units of risk-weighted assets at a bank, a ratio of 12%. The regulator's minimum plus buffers comes to 10.5%, so the bank has a margin. When it plans fast loan growth that would lift risk-weighted assets to 120, the ratio would fall to 10%, under the 10.5% requirement, and the bank must raise capital or slow the growth.