What You need to know Capital Adequacy Ratios Capital Adequacy Zones Practice  

Capital is necessary for your bank to operate. It serves as a cushion that absorbs losses and declines in the value of assets. While many areas of your bank are important and subject to scrutiny, capital adequacy is the area that triggers the most regulatory action. This regulatory action is the result of the the Federal Deposit Insurance Corporation Improvement Act of 1991, which created a link between enforcement actions and the level of capital held by a bank. This supervisory link is commonly known as Prompt Corrective Action (PCA) and aims to resolve banking problems early and at the least cost to the bank insurance fund.

Prompt Corrective Action is largely based on the three major ratios used in the assessment of capital adequacy, which are:

  • The Tier 1 Risk-Based Capital Ratio.
  • The Total Risk-Based Capital Ratio.
  • The Tier 1 Leverage Ratio.

It is important to note that as these ratios decline below certain levels, a bank automatically comes under increasingly strict limitations in accordance with prompt corrective action (for purposes of which the bank is classified as well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized). There is very little latitude on the part of the regulatory agencies in this process.

Further, even if the ratios do not decline below the specified levels, regulators may have concerns about a bank’s capital adequacy, depending on its risk profile. That is, if your bank has excessive asset quality and earnings problems, more capital will likely be necessary.

Lesson Objectives

After you complete this lesson, you should be able to:

  • Understand the calculation of the Tier 1 Risk-Based Capital Ratio, the Total Risk-Based Capital and the Tier 1 Leverage Ratio.
  • Understand other factors that go into an assessment of capital adequacy.
  • Understand the “Prompt Corrective Action” (PCA) capital adequacy zones (sometimes referred to as categories).
  • Understand the major restrictions that face banks in the PCA zones.

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