What is meant by "capital adequacy" in banking?

"Capital adequacy" refers to the capacity of a bank to maintain sufficient capital reserves to absorb potential losses while still meeting its obligations to depositors and other creditors. It is essentially a measure that assesses a bank's capital in relation to the risks it assumes through its lending and investment activities. This concept plays a crucial role in ensuring the stability of the banking system, as it helps safeguard against insolvency by requiring banks to maintain a minimum level of capital based on the risks they are exposed to.

The calculation of capital adequacy usually involves comparing the bank's capital—its equity and retained earnings—to its risk-weighted assets, which represent the various levels of risk associated with each type of asset on the balance sheet. A higher capital adequacy ratio indicates a better buffer against potential losses, thus reflecting the bank's financial health and its ability to withstand adverse economic conditions.

In contrast, measures of asset quality pertain to the performance and risk of the bank's assets, guidelines for loan-to-value ratios focus on lending practices, and strategies to attract investors involve broader financial strategies and do not specifically relate to the requirements placed on banks concerning their capital levels.