The bank capital is the sum of resources a bank can use against insolvency risks. Its assets include share capital, retained earnings, and loans issued.
The bank capital to asset ratio is an important measure to understand the bank’s financial stability.
Let us discuss the bank capital to asset ratio, how it is calculated, and its important components.
Bank Capital to Asset Ratio
The bank capital to asset ratio is also called the capital adequacy ratio of capital to risk-weighted asset ratio of a bank.
The bank capital to asset ratio measures the total capital held by a bank against its assets. It measures the ability of a bank to protect its solvency. It denotes the ability of a bank to pay its liabilities using its capital and assets.
Since banks provide crucial economic support to an economy in any country, their financial stability is critical.
Regulatory authorities and central banks set certain requirements for commercial banks to maintain financial stability.
The capital adequacy ratio is one of such critical requirements for banks. The ratio is a useful measure not only for regulatory authorities but for bank management as well.
Central banks or regulatory authorities set every country’s minimum capital adequacy ratio. Generally, the higher the ratio the better it is for the bank as it measures the financial strength of the bank.
How to Calculate the Bank Capital to Asset Ratio?
Regulatory authorities divide the bank capital into different tiers. Usually, tier 1 and tier 2 capital categories are considered in important calculations.
The assets held by a bank can be found on its balance sheet. However, an important variation of the bank’s assets is calculating the risk-weighted assets instead of using the simple total asset value. (Discussed below in detail)
The first step is to calculate the bank’s tier 1 and tier 2 capital. Tier 1 capital includes shareholders’ equity and retained earnings.
Tier 2 includes a bank’s reserves and loans issued.
The second step is to calculate the bank’s total assets or risk-weighted asset figure. If the analysts calculate the risk-weighted assets, they must assign the risk coefficient issued by reputed rating agencies to a bank’s assets.
Finally, we can divide a bank’s total capital by its total assets or risk-weighted assets.
The formula is given below:
Capital Adequacy Ratio = Total Bank Capital / Risk-Weighted Assets
Total Bank Capital = Tier 1 Capital + Tier 2 Capital
Risk-weighted assets can be calculated by multiplying the assets in a particular category with their risk coefficient issued by a rating agency.
For example, the risk coefficient for US treasury bills is 0%. Thus, if a bank has $ 10 million of US treasury securities, its risk-weighted value will also be $ 10 million.
Minimum Requirement for Bank Capital to Asset Ratio
Central banks or regulatory authorities set the minimum requirements for bank capital to asset ratios worldwide.
However, the Basel Committee on Bank Supervision issued international banking standards. These standards are commonly known as Basel I, Basel II, and Basel III.
Under Basel III, a bank needs to maintain a banking capital to asset or capital adequacy ratio of 8%. Basel II requires a bank to maintain a minimum of 10.5% capital adequacy ratio.
Regulators may further evaluate the financial strength of a bank. For instance, since tier 1 capital is more important, the regulatory authorities may evaluate only the tier 1 to assets ratio.
Under Basel III, a bank must maintain a minimum of 6% tier 1 to risk-weighted assets ratio.
Let us discuss an example to understand the capital adequacy ratio.
Suppose a bank ABC has the following information available.
Tier 1 Capital: $ 500 million
Tier 2 Capital: $ 200 million
Total Capital: $ 700 million
Debentures: $ 1,500 million
Mortgages: $ 2,000 million
Loans to Government Entities: $ 1,450 million
Reserves and Retained Earnings: $ 1,050 million
Total Assets: $ 6,000 million
Capital to Assets Ratio = Total Capital / Total Assets
Capital to Assets Ratio = 700/6,000 = 11.66%
If we consider risk-weighted assets, then the capital adequacy ratio would be different.
The credit ratings will assign a 0% risk coefficient to retained earnings and loans to government entities.
Thus, both line items in the asset list will carry full weightage.
We assume the risk coefficient for debentures and mortgages are 85% and 80% respectively. Then,
Risk-weighted Debentures: 1,500 × 85% = 1,275 million
Risk-weighted Mortgages: 2,000 × 80% = 1,600 million
Thus, total risk-weighted assets = 1,275 + 1,600 + 1,450 + 1,050 = 5,375
Now the risk adequacy ratio can be calculated as:
Risk Adequacy Ratio = Total Capital / Risk-Weighted Assets
Risk Adequacy Ratio = 700/5,375 = 13%
The bank maintains an adequate capital to risk-weighted average that is well above the required limit of 10% and 8% for Basel II and Basel III standards.
Understanding Bank Capital
We can define bank capital in several ways. The most common definition is the difference between a bank’s assets and liabilities is called bank capital.
On a bank’s balance sheet, we can see its assets that include commercial loans, debentures, mortgages, and fixed assets.
We can see a bank’s loans, short-term obligations, and shareholders’ equity on the liabilities side.
Banking standards define bank capital as the bank’s ability to repay its liabilities and absorb losses.
Thus, regulatory authorities consider a bank’s capital differently. It is termed as regulatory capital of a bank.
The regulatory capital is further divided into tier 1 and tier 2 categories.
Tier 1 Capital
Tier 1 capital is the main source of capital for a bank. It includes equity share capital, retained earnings, reserves, and intangible assets that a bank can use primarily to secure itself from insolvency.
Tier 2 Capital
Tier 2 capital absorbs a bank’s losses if it goes into liquidation. It included unaudited retained earnings, unaudited reserves, and other short-term assets.
Tier 2 capital also includes subordinated debt and surplus stocks. Usually, it includes debts and other instruments with a maturity period of fewer than five years.
Risk-Weighted Assets of a Bank
A key component of the capital adequacy ratio is the calculation of risk-weighted assets of the bank.
Regulatory authorities and credit rating agencies assign risk scores to asset classes. Analysts then use that score to determine the risk weightage of each type of asset.
Combined these values can give us the total risk-weighted assets of a bank. The purpose of assigning the risk coefficient is to analyze the ability of each type of asset class to protect the bank against insolvency.
Analyzing the Capital to Asset Ratio
Generally, the higher the capital to asset ratio of a bank, the safer it is. As long as the capital adequacy ratio is above the Basel III standards, it can be considered good.
Analysts can dig deeper to analyze the capital to-asset ratio further. One way of evaluating the ratio is to separate the tier 1 and tier 2 capital. Many analysts analyze the tier 1 to assets ratio instead of using the total assets figure.
Similarly, analysts must consider other important performance metrics such as a bank’s liquidity in conjunction with the capital adequacy ratio. It provides a complete picture of the financial stability of a bank.