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. Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.
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, comprises 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 given a weight.
Currently, the minimum ratio of capital to risk weight assets is 8% under Basel II and 10.5% under Basel III. High capital adequacy ratios are above the minimum requirements under Basel II and Basel III.
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% (($10 million + $5 million) / $50 million). Therefore, this bank has a high capital adequacy ratio and is considered safer. Bank ABC is less likely to become insolvent if unexpected losses occur.