Banking awareness : Capital adequacy ratios

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Banking awareness : Capital adequacy ratios

Capital adequacy ratios are a measure of the amount of a bank’s capital expressed as a percentage of its risk weighted credit exposures.

An international standard which recommends minimum capital adequacy ratios has been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent.

Applying minimum capital adequacy ratios serves to protect depositors and promote thestability and efficiency of the financial system.

Two types of capital are measured – tier one capital which can absorb losses without a bankbeing required to cease trading, e.g. ordinary share capital, and tier two capital which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors, e.g. subordinated debt.

Measuring credit exposures requires adjustments to be made to the amount of assets shown on a bank’s balance sheet. The loans a bank has made are weighted, in a broad brush manner, according to their degree of riskiness, e.g. loans to Governments are given a 0 percent weighting whereas loans to individuals are weighted at 100 percent.

Off-balance sheet contracts, such as guarantees and foreign exchange contracts, also carry credit risks. These exposures are converted to credit equivalent amounts which are also weighted in the same way as on-balance sheet credit exposures. On-balance sheet and offbalance sheet credit exposures are added to get total risk weighted credit exposures.

The minimum capital adequacy ratios that apply are:

i) tier one capital to total risk weighted credit exposures to be not less than 4 percent;

ii) total capital (tier one plus tier two less certain deductions) to total risk weighted credit
exposures to be not less than 8 percent.

Capital Adequacy Ratio Formula = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets

The total capital which is the numerator in the capital adequacy ratio is the summation of Tier 1 capital of the bank and tier 2 capital of the bank.

The tier 1 capital which is also known as the common equity tier 1 capital includes mainly share capital, retained earnings, other comprehensive income, intangible assets, and other small adjustments.

The tier2 capital of a bank includes revaluation reserves, subordinated debt, and related stock surpluses.

The denominator is risk-weighted assets. The risk-weighted assets of a bank include credit risk-weighted assets, market risk-weighted assets, and operational risk-weighted assets. The ratio is represented in the form of a percentage; generally higher percentage implies safety for the bank.