Question

3.How does capital adequacy serve as a regulatory tool in mitigating system-wide risk?

Answer 1

Capital adequacy ratio measures the amount of tier 1 and Tier 2 capital required to manage risk weighted assets. Tier 1 capital is the amount which can provide cushion against losses for the continuing operation of a bank whereas Tier II capital manages the capital maintained in case bank is winding up.

Capital adequacy ratio or the capital is also called counter cyclical buffer. This buffer protects the banking system when there is an economic shock or recession or downturn. This this capital cannot be laoned out excess credit cannot be created in the economy. Recession has been linked excess credit growth. By limiting credit growth system wide risk can be mitigated.