Financial Requirements and Capital Adequacy
What the domain tests
This domain tests minimum capital, eligible capital tiers, risk-weighted assets, buffers, liquidity, leverage, recovery planning and breach notification.
Core rules and concepts
- Capital is ranked by loss-absorbing quality. Common Equity Tier 1 is the strongest; Additional Tier 1 and Tier 2 are weaker and subject to limits.
- Capital adequacy is a ratio, not a nominal amount: eligible capital divided by risk-weighted assets. Assets are weighted by credit, market and operational risk.
- Deductions from capital, such as goodwill and some intangibles, prevent overstated resources.
- Buffers sit above minimum requirements and can restrict distributions when breached. Liquidity requirements are separate from capital and test cash and high-quality liquid assets against stressed outflows.
- A breach or likely breach triggers prompt notification, remediation and possibly restrictions on business.
Worked example
A firm has CET1 of 80, Additional Tier 1 of 10, Tier 2 of 10 and risk-weighted assets of 500. CET1 ratio is 80/500 = 16%; total capital ratio is 100/500 = 20%. If goodwill of 5 is deducted, CET1 becomes 75 and the CET1 ratio falls to 15%. The lesson is to apply deductions before calculating ratios and to distinguish CET1 from total capital.
Traps that cost marks
Counting subordinated debt as CET1; ignoring deductions; comparing nominal capital with a minimum amount instead of a ratio; and forgetting that liquidity and leverage are separate tests.