Definition of the risk-adjusted capital ratio
What is the risk-adjusted capital ratio?
The risk-adjusted capital ratio is used to assess a financial institution’s ability to continue operating during an economic downturn. It is calculated by dividing the total adjusted capital of a financial institution by its risk-weighted assets (RWA).
Key points to remember
- The risk-adjusted capital ratio is used to assess a financial institution’s ability to continue operating during an economic downturn.
- It is calculated by dividing the total adjusted capital of a financial institution by its risk-weighted assets (RWA).
- The risk-adjusted capital ratio allows comparisons between different geographies, including comparisons between countries.
Understanding the risk-adjusted capital ratio
The risk-adjusted capital ratio measures the resilience of a financial institution’s balance sheet, with an emphasis on capital resources, to deal with a given economic risk or recession. The higher the capital of the institution, the higher its capital ratio, which should translate into a higher probability that the entity will remain stable in the event of a severe economic downturn.
The denominator of this ratio is somewhat complicated, as each asset owned must be measured against its ability to perform as intended. For example, an income-generating factory is not guaranteed to generate positive cash flow. Positive cash flow could depend on capital costs, plant repair, maintenance, collective bargaining and many other factors.
Calculation of the risk-adjusted capital ratio
Determining total adjusted capital is the first step in determining the risk adjusted capital ratio. Total adjusted capital is the sum of equity and quasi-equity instruments adjusted for their equity content.
Next, the value of risk weighted assets (RWA) is measured. The value of RWA is the sum of each asset multiplied by the individual risk assigned to it. This number is expressed as a percentage and reflects the chances that the asset will retain its value, that is, it will not lose its value.
For example, cash and treasury bills have an almost 100% chance of remaining solvent. Mortgages would likely have an intermediate risk profile, while derivatives should be assigned a much higher risk quotient.
The final step in determining the risk-adjusted capital ratio is to divide the total adjusted capital by the RWA. This calculation will give the risk-adjusted capital ratio. The higher the risk-adjusted capital ratio, the better the financial institution’s ability to withstand an economic downturn.
Standardization of risk-adjusted capital ratios
The goal of a risk-adjusted capital ratio is to assess an institution’s actual risk threshold with a higher degree of precision. It also allows comparisons between different geographic locations, including comparisons between countries.
The Basel Committee on Banking Supervision initially recommended these standards and regulations for banks in a document called Basel I. The recommendation was that banks hold enough capital to cover at least 8% of their RWA.
Basel II sought to extend the standardized rules set out in the previous version and promote the effective use of disclosure as a means of strengthening markets. Basel III further refined the document, stating that the calculation of RWAs would depend on which version of the document was followed.