The capital adequacy ratio, also known as capital to risk-weighted assets ratio, measures a bank's financial strength by using its capital and assets. It is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.
How the Capital Adequacy Ratio Is Calculated
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets. The capital used to calculate the capital adequacy ratio is divided into two tiers.
Tier-one capital, or core capital, is comprised of equity capital, ordinary share capital, intangible assets, and audited revenue reserves. Tier-one capital is used to absorb losses and does not require a bank to cease operations.
Tier two capital comprises unaudited retained earnings, unaudited reserves, and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating.
The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans, evaluating the risk, and then assigning a weight.
The Minimum Ratio of Capital to Risk-Weighted Assets
Currently, the minimum ratio of capital to risk-weighted assets is eight percent under Basel II and 10.5 percent under Basel III. High capital adequacy ratios are above the minimum requirements under Basel II and Basel III.
Minimum capital adequacy ratios are critical in ensuring that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors’ funds.
For example, suppose bank ABC has $10 million in tier-one capital and $5 million in tier-two capital. It has loans that have been weighted and calculated as $50 million. The capital adequacy ratio of bank ABC is 30 percent (($10 million + $5 million) / $50 million). Therefore, this bank has a high capital adequacy ratio and is considered to be safer. As a result, Bank ABC is less likely to become insolvent if unexpected losses occur.