Capital Adequacy Ratio: A Managerial Framework

JM Magnette

This article was first published as a chapter in Managing Systemic Exposure, by Risk Books.

Managers of systemically important financial institutions (SIFIs) need to establish explicitly the risk appetite of their institution, taking into account not only the capital structure (including leverage), but also the target level of solvency.

The language of risk management commonly used by managers is now based on the guidance provided by the Basel Committee on Banking Supervision: key terms are “risk-weighted assets” and “capital adequacy ratio”. However, the Basel Committee does not explicitly set a level of solvency for SIFIs, it simply requires that they provide for a higher percentage of risk-weighted assets to be covered by their own funds compared to non-systemically important financial institutions.

Rating agencies have also developed new rules which give indications on the appropriate level of the capital adequacy ratio in order to obtain a given rating.

This chapter will explicitly connect the language of the Basel Committee with the level of solvency. More specifically, it determines the level of the capital ratio compatible with a target solvency level of the financial