Capital adequacy

What it means

Capital adequacy is a regulatory ratio that compares a bank's own funds with its risk-weighted assets. It shows how much capital a bank must hold to absorb possible losses on loans and other business, and therefore how much it can lend.

The rules are based on the international Basel III standards, implemented in the EU through the Capital Requirements Regulation. The minimum total capital ratio is 8% of risk-weighted assets, on top of which come additional capital buffers set by the supervisor, in Slovakia the National Bank of Slovakia.

Risk weights depend on the type of exposure. A loan well secured on property or made to the state carries a lower weight than an unsecured loan to a small business. Financing riskier clients is therefore more capital-intensive for a bank, which shows up in loan pricing and terms.

How it works in practice

For a business owner, capital adequacy has an indirect effect. When banks need more capital, they tighten approvals, ask for more security such as a lien or guarantee, and favour clients with a proven track record and good-quality accounts.

A bank assesses a client's risk partly through its financial statements, equity, indebtedness and cash flow. A company with low equity or losses receives a worse internal rating and hence a higher risk weight, which the bank reflects in a higher interest margin.

Banks often include covenants in loan agreements, such as a minimum equity ratio or a maximum debt-to-EBITDA ratio. These conditions protect the bank and indirectly its capital position; breaching them can lead to a higher rate or early repayment.

What to watch out for

Capital adequacy applies to the bank, not the company, but a company should keep an eye on its bank's stability too. Deposits are protected up to a limit, yet if a bank runs into serious trouble, drawing on credit lines may be restricted, so it is sensible not to have all financing with a single bank.

Non-bank lenders are not subject to the same capital rules and so tend to be more flexible in approving loans. That flexibility usually comes at the price of higher interest and stricter penalties, so compare the total cost, not just the speed of approval.