What Is Risk-Adjusted Capital Ratio?
The risk-adjusted capital ratio is used to gauge a financial institution's ability to continue functioning in the event of an economic downturn. It is calculated by dividing a financial institution's total adjusted capital by its risk-weighted assets (RWA).
Understanding the Risk-Adjusted Capital Ratio
A risk-adjusted capital ratio measures the resilience of a financial institution's balance sheet, with an emphasis on capital resources, to endure a given economic risk or recession. The greater the institution's capital, the higher its capital ratio, which should translate to a higher probability that the entity will remain stable in the event of a severe economic downturn.
The denominator in this ratio is somewhat complicated, as each asset owned must be rated by its ability to perform as expected. For example, an income-producing factory is not assured to generate positive cash flow. Positive cash flow could depend on capital costs, plant repair, maintenance, labor negotiations, and many other factors. For a financial asset, such as a corporate bond, profitability depends on interest rates and the default risks of the issuer. Bank loans typically come with a loss allowance.
Calculating the Risk-Adjusted Capital Ratio
Determining your total adjusted capital is the first step in figuring out the risk-adjusted capital ratio. Total adjusted capital is the sum of equity and near-equity instruments adjusted by their equity content.
Next, the value of risk-weighted assets (RWA) is measured. The value of RWA is the sum of each asset multiplied by its assigned individual risk. This number is stated as a percentage and reflects the odds that the asset will retain its value, i.e., not become worthless.
For example, cash and Treasury bonds have almost a 100% chance of remaining solvent. Mortgages would likely have an intermediate risk profile, while derivatives should have a much higher risk quotient attributed to them.
The final step in determining the risk-adjusted capital ratio is to divide the total adjusted capital by the risk-weighted assets (RWA). This calculation will result in the risk-adjusted capital ratio. The higher the risk-adjusted capital ratio, the better the ability of the financial institution to withstand an economic downturn.
Standardization of Risk-Adjusted Capital Ratios
The purpose of a risk-adjusted capital ratio is to evaluate an institution's actual risk threshold with a higher degree of precision. It also allows comparisons across different geographical locations, including comparisons across countries.
The Basel Committee on Banking Supervision initially recommended these standards and regulations for banks in a document called Basel I. The recommendation was that banks should carry enough capital to cover at least 8% of their risk-weighted assets. Basel II sought to expand the standardized rules set out in the earlier version and to promote the effective use of disclosure as a way to strengthen markets. Basel III refined the document further stating the calculation of risk-weighted assets would depend on which version of the document was being followed.