Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 2 The emerging practices in this white paper are intended to be a resource for companies in measuring and evaluating their capital adequacy. There is no implication, however, that the individual members of the CCRO will adopt or reject any or all of the practices herein. This document does not create any legally enforceable obligations or duties for the members of the CCRO or any other entity. Adoption of and adherence to any of the practices set forth herein by any company are voluntary. The emerging practices in this white paper do not change or modify any legal or professional requirements for companies and should be construed so as not to conflict with any applicable legal or professional requirements. Compliance with the emerging practices does not relieve any company from meeting its legal and professional obligations. Therefore, regardless of whether a company adopts, rejects, or modifies any or all of the emerging practices contained herein, companies should be mindful of their legal and professional obligations. Companies should adopt specific emerging practices as appropriate based on their individual circumstances and needs. There is a broad distinction between regulated utilities and asset-based merchant/trading companies. Some entities participate in both these activities, in which case the activities may be measured separately under different approaches yet combined in the end to measure overall capital adequacy. Nonetheless, capital adequacy is important for all types of organizations, and this white paper identifies emerging methods to measure an entity’s capital adequacy. The CCRO recognizes that after the issuance of these emerging practices, companies may require a substantial transition period for adoption and implementation. Furthermore, the emerging practices are not deemed to be static. They will change and adapt on a continuing basis to remain relevant. The CCRO expects that the emerging practices will evolve and further develop through future investigations by the CCRO and the efforts and experience of companies adopting and implementing them. 1.1 The Concept of Capital Adequacy Capital adequacy is a potentially vital financial metric designed to assess a company’s short- and long-term outlook for financial health. Many financial metrics emphasize the “returns” for measuring financial performance. Capital adequacy emphasizes “sufficient capital” to meet adverse events. Capital is a key barometer of financial health, providing investors assurances that the company is viable and can weather uncertain outcomes. A robust assessment of capital adequacy requires an analysis of and balance between two measurements ― economic value and financial liquidity (Figure 1). For a company to have an adequate capital level, it must simultaneously possess the capacity to create sufficient economic value for its customers and shareholders and the sources of liquidity to meet maturing obligations under adverse conditions. Insufficiencies in either measure will create inadequacy for the business as a going concern and will hinder its ability to create value. In the context of capital adequacy for this white paper, economic value and financial liquidity have the following connotations: • Economic value relates to the ability of a company to execute its planned business activities aimed at creating or providing products and services for existing or new customers while creating or enhancing shareholder value. The general state of the global economy and