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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

A regulator raises the minimum capital adequacy ratio for banks. In the short run, which is the most likely effect on a bank that wishes to keep its capital in rupees unchanged?

The bank must cut its risk-weighted assets or raise additional capital, which can restrict lending. Since the ratio is capital divided by risk-weighted assets, a higher minimum with unchanged capital lowers the assets it can support and reduces permitted leverage.

  1. AIt can expand its risk-weighted assets by more than before
  2. BIt must reduce risk-weighted assets or raise more capital, which may restrict lendingCorrect
  3. CIts leverage rises automatically
  4. DIts liquidity coverage falls to zero
  5. Its deposit insurance premium is abolished

Explanation

Capital ratio equals capital divided by risk-weighted assets. With capital fixed and a higher required ratio, the bank must shrink risk-weighted assets or raise capital, so lending may be curtailed. Higher requirements lower, not raise, permitted leverage.

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