Capital Adequacy System

Bank's assets are maintain in the form of cash, deposits in the central bank and other fellow banks, investments, bills discounted and loans and advances. Some of assets are liquid, some semi-liquid and so0me remotely- liquid. In the same way, banks undertake various off-balance- sheets transactions such as LC issuance, guarantee issuance which are contingent liabilities. Higher the risk associated with each component of assets and contingent items, higher is the risk associated with it.

The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted (see Risk-weighted asset). Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence each country's banking capital requirements.
The main purpose of measuring capital adequacy is to give protection to the depositors and creditors by maintaining a higher balance of risk free assets and by increasing their capital base. Banks having adequate capital enjoys more public confidence and share value of such banks are higher in the share market. Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework.Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate. Banks are instructed to maintain capital adequacy ratio at 6% of core capital and 12% in total fund. However, this will be changed to 8% of total capital fund after the implementation of basle-II accord.