Calculating the Capital-To-Risk Weighted Assets Ratio for a Bank

The capital-to-risk weighted assets ratio, also known as the capital adequacy ratio, is one of the most important financial ratios used by investors and analysts. The ratio measures a bank’s financial stability by measuring its available capital as a percentage of its risk-weighted credit exposure. The purpose of the ratio is to help banks protect their depositors and promote financial health.

The capital-to-risk-weighted assets ratio for a bank is usually expressed as a percentage. The current minimum requirement of the capital-to-risk weighted assets ratio, under Basel III, is 10.5%, including the conservation buffer. Having a global standard promotes the stability and efficiency of worldwide financial systems and banks.

Key Takeaways

• The capital-to-risk-weighted assets ratio is used to represent the financial solvency of a bank.
• The ratio is calculated by dividing a bank’s total capital by it’s risk-weighted assets.
• Under the Basel III accord, the minimum requirement of capital-to-risk weighted assets is 10.5%.

Formula for the Capital-To-Risk Weighted Assets Ratio

The formula to calculate a bank’s capital-to-risk weighted assets ratio is:

Capital-To-Risk Weighted Assets=Risk-Weighted AssetsTier 1 Capital+Tier 2 Capital​

Tier 1 capital is the core capital of a bank; the capital it needs to absorb losses without stopping operations. It includes equity and disclosed reserves. Tier 2 capital is supplementary capital that is less secure than tier 1 capital. It includes undisclosed reserves and subordinated debt. A bank’s risk-weighted assets are its assets weighted by their riskiness used to determine the minimum amount of capital that must be held to reduce its risk of insolvency. These items can all be found on a bank’s financial statements.

10.5%

The minimum capital-to-risk weighted assets ratio, under the Basel III accord. This was originally 8%, but a conservation buffer of 2.5% was added in 2019.

Example of the Capital-To-Risk Weighted Assets Ratio

Assume bank ABC has tier 1 one capital of $10 million and tier 2 capital of $5 million. It has $400 million in risk-weighted assets. The resulting capital to risk-weighted assets ratio is 3.75%:



Capital-to-risk weighted assets=$400MM$10MM+$5MM​×100%

With a ratio significantly below 10.5%, bank ABC has not met the minimum requirement of capital-to-risk weighted assets. The bank is holding too much in risk-weighted assets, in comparison with its tier 1 and tier 2 capital.

On the other hand, assume bank DEF has tier 1 capital of $15 million, tier 2 capital of $10 million, and $75 million in risk-weighted assets. Bank DEF’s resulting capital-to-risk weighted assets ratio is 33%:



Capital-to-risk weighted assets=$75MM$15MM+$10MM​×100%

Therefore, bank DEF is financially stable, likely to be able to absorb its losses.

What Are Risk-Weighted Assets?

A bank’s risk-weighted assets represents the value of the bank’s portfolio of loan assets, weighted with a multiplier representing the risk of each loan. For example, loans that are secured by collateral have a lower risk value than unsecured loans, and borrowers with a high credit rating have a lower risk value than those with a lower rating. Cash is considered the least risky asset. Taken together, the bank’s risk-weighted assets is used to calculate the bank’s ability to pay its obligations if it is placed under financial stress.

What Is the Tier 1 Capital Ratio?

Tier 1 capital represents a bank’s core capital—the value of all common shares issued by the bank, as well as its retained earnings and disclosed reserves. In the event of a financial crisis, this capital will be used to repay the bank’s obligations before any depositors are affected.

What’s the Difference Between Capital Adequacy and the Solvency Ratio?

The capital adequacy ratio (CAR) and solvency ratio are both metrics used to measure a company’s ability to withstand financial losses. The main difference is that capital adequacy measures a bank’s capital in comparison with its loan obligations, whereas solvency measures a company’s ability to pay its financial obligations with cash on hand. The solvency ratio can be applied to all companies, but capital adequacy is used exclusively for banks and other financial institutions.

The Bottom Line

The capital-to-risk weighted assets ratio will help determine whether or not a bank has enough capital to take on any losses before becoming insolvent and losing depositor funds. It’s important for a bank to monitor this ratio and adhere to regulatory requirements to avoid going insolvent and to protect its clients and the larger economy as a whole.