The premise behind capital adequacy is that an entity should assess its risks and hold capital that is commensurate with its risk profile and control environment.
In markets and sectors such as financial services where the risk of contagion or domino effect is high Capital Adequacy is used as a primary regulatory tool. Regulators use Capital Adequacy to ensure that new entrants as well as existing players have crossed a minimum threshold of required capital and that the threshold changes based on market conditions as well as balance sheet profile of the institution in question.
While the thinking can be applied to any prudent business, it is enforced specifically for banking, brokerage and insurance industry under the ambit of Basel II, Basel II, The EU Capital Adequacy Directive (CAD) and the Solvency II regime for insurance industry.
In calculating capital that is required the entity would need to consider all material risks in the business. Usually the level of capital to be held would be above the minimum requirements stated in regulation such as Basel II.
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