The capital adequacy ratio, also known as capital to risk-weighted assets, measures the financial stability of the Bank using its capital and assets. It is used to protect depositors and promote the stability and efficiency of financial systems around the world. Usually, a Bank with a high capital adequacy ratio is safe and is likely to meet its financial obligations.
As the capital adequacy ratio is calculated
The capital adequacy ratio is calculated by dividing a Bank’s capital to its assets, weighted by risk. Capital is used to calculate the capital adequacy ratio is divided into two tiers.
Of tier I capital, or core capital, consisting of share capital, ordinary shares, intangible assets and audit of revenue reserves. Capital is used to cover losses and do not require the Bank to cease operations.
Two tier I capital includes unaudited retained earnings unaudited reserves and General reserves for possible losses. This capital absorbs losses in the event of liquidation of the company or liquidation.
Two major levels are summed and divided by risk-weighted assets for calculation of capital adequacy ratio of the Bank. Risk-weighted assets are calculated by looking at Bank loans, risk assessment, and then is assigned a weight.
The minimum ratio of capital to risk-weighted assets
Currently, the minimum ratio of capital to risk-weighted assets is eight percent in accordance with Basel II and 10.5% under Basel III. High capital adequacy ratios above the minimum requirements of Basel II and Basel III.
Minimum capital ratios are crucial to ensure that banks have enough cushion to absorb reasonable amount of losses before they become insolvent and, as a consequence, lose their depositors ‘ funds.
For example, suppose the ABC Bank has $ 10 million in capital and $5 million in two capital. These are loans that have been weighted and calculated as $ 50 million. The capital adequacy ratio of the Bank AVS 30% (($10 million + 5 million) / $50 million). Thus, the Bank has high capital adequacy ratios and is considered more secure. As a result, Bank ABC is less likely to become insolvent if unexpected losses.