The capital-to-risk-weighted assets ratio, also known as the capital adequacy ratio, measures a bank's capital in relation to its assets' exposure to risk. The formula to calculate a bank's capital adequacy ratio is the bank's tier-one capital, plus its tier-two capital divided by the risk-weighted assets. Tier-one capital is used to absorb a bank's losses, without it having to cease its business operations. A bank's tier-two capital is used in the event that the bank winds up its assets.
The capital-to-risk-weighted assets ratio for a bank is usually expressed as a percentage. The current minimum of the total capital to risk-weighted assets, under Basel III, is 10.5%. Having a global standard promotes stability and efficiency of worldwide financial systems and banks.
For example, assume bank ABC has tier one capital of $10 million and tier two capital of $5 million. It has $400 million in risk-weighted assets. The resulting capital to risk-weighted assets ratio is 3.75%:
Capital-to-risk weighted assets=$400MM$10MM+$5MM×100%
With a ratio significantly below 10.5%, bank ABC has not met the minimum requirement of capital risk-weighted assets. The bank is holding too much in risk-weighted assets, in comparison with its tier-one and tier-two capital.
On the other hand, assume bank DEF has tier-one capital of $15 million, tier-two capital of $10 million, and $75 million in risk-weighted assets. Bank DEF's resulting capital to risk-weighted assets ratio is 33%:
Capital-to-risk weighted assets=$75MM$15MM+$10MM×100%
Therefore, bank DEF is financially stable, likely to be able to absorb its losses.