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Capital Adequacy Ratio

 

Capital adequacy ratio is the main financial ratio for banks to measure whether the bank has enough of capital on which depends the riskiness of the bank. Banks are borrowing money from other depositors and it is very important that banks would remain solvent and liquid; otherwise, they could harm whole financial system and economy. Because of this reason banks are supervised by authorities very strictly and ‘capital adequacy ratio’ is one of the main tools to measure bank’s risk level.  

 

Capital adequacy ratio formula


Capital adequacy ratio = (Tier I capital + Tier II capital) / Risk weighted assets

 

Tier I capital = Share capital + Share premium + Retained earnings – Intangible assets – Current year’s loss

 

Tier II capital = Revaluation reserve + Subordinated debt + General provisions

 

Risk weighted assets are equal to classified asset portfolio where each asset class is multiplied by its risk weighting. 

 

* There are some limitations for Tier II capital in relation to Tier I capital. Different supervisory institutions may have different methodology of this ratio calculation while Basel requirements also change over time.

 

The minimum ‘capital adequacy ratio’ is set in each country by supervising authority and may be different (average is about 10%). Also it may change over time. If ‘capital adequacy ratio’ of the bank is lower (or very close to the margin) than required minimum, authorities may ask for assurance that bank’s capital will be increased. If bank’s owners fail to increase the capital, government may take the bank under receivership or may suspend the license of the bank. 

 






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