The capital-to-risk weighted assets ratio, also known as the capital adequacy ratio, is one of the most important financial ratios used by investors and analysts. The ratio measures a bank's financial stability by measuring its available capital as a percentage of its risk-weighted credit exposure. The purpose of the ratio is to help banks protect their depositors and promote financial health.
The capital-to-risk-weighted assets ratio for a bank is usually expressed as a percentage. The current minimum requirement of the capital-to-risk weighted assets ratio, under Basel III, is 10.5%, including the conservation buffer. Having a global standard promotes the stability and efficiency of worldwide financial systems and banks.
The Formula for the Capital-To-Risk Weighted Assets Ratio
The formula to calculate a bank's capital-to-risk weighted assets ratio is:
Capital-To-Risk Weighted Assets = (Tier 1 Capital + Tier 2 Capital / Risk-Weighted Assets)
Tier 1 capital is the core capital of a bank; the capital it needs to absorb losses without stopping operations. It includes equity and disclosed reserves. Tier 2 capital is supplementary capital that is less secure than tier 1 capital. It includes undisclosed reserves and subordinated debt. A bank's risk-weighted assets are its assets weighted by their riskiness used to determine the minimum amount of capital that must be held to reduce its risk of insolvency. These items can all be found on a bank's financial statements.
Example of the Capital-To-Risk Weighted Assets Ratio
Assume bank ABC has tier 1 one capital of $10 million and tier 2 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-to-risk weighted assets. The bank is holding too much in risk-weighted assets, in comparison with its tier 1 and tier 2 capital.
On the other hand, assume bank DEF has tier 1 capital of $15 million, tier 2 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.
The Bottom Line
The capital-to-risk weighted assets ratio will help determine whether or not a bank has enough capital to take on any losses before becoming insolvent and losing depositor funds. It's important for a bank to monitor this ratio and adhere to regulatory requirements to avoid going insolvent and to protect its clients and the larger economy as a whole.