Raising the capital adequacy ratio would have which effect on banks' lending capacity?

• A. Increases lending capacity
• B. Reduces lending capacity
• C. No impact on lending capacity
• D. Encourages lending to riskier borrowers

Answer: (B)

Raising the capital adequacy ratio means banks must hold more capital relative to their risk-weighted assets. Capital serves as a cushion to absorb losses, and the ratio limits how much risk-weighted lending a bank can support. If the required ratio goes up and the bank doesn’t astoundingly increase its capital, it must either shrink its risk-weighted assets (lending) or reduce the mix of assets to stay compliant. In short, higher capital requirements tie up more funds as capital backing each unit of lending, so the maximum lending capacity is reduced unless more capital is raised or risk-weighted assets are cut.