Capital Adequacy Ratio

Formula

Capital adequacy is a measure to find out the proportion of banks capital, with respect to the total risk weighted assets of the bank. 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 for the calculation of capital adequacy ratio is risk weighted assets. The risk weighted assets of a bank includes 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.

Capital adequacy ratio= (Tier 1 + Tier 2 capital)/risk weighted assets

Example

Simple example

Let us try to understand the Capital adequacy ratio of an arbitrary bank in order to understand how to calculate the ratio for banks. For calculating Capital adequacy ratio we need to assume the tier 1 and tier 2 capital of the bank. We also need to assume the risk associated with its assets, those risks weighted assets are Credit risk weighted assets, and Market risk weighted assets and Operational risk weighted assets. The snapshot below represents the calculation of Capital adequacy ratio, with all the variables required to calculate the Capital adequacy ratio.

Bank A ($ millions)
Tier 1 Capital   148
Tier 2 Capital   57
Total Capital   205
Credit risk weighted assets   1200
Market risk weighted assets   350
Operational risk weighted assets   170
Total Risk weighted assets   1720
Capital Adequacy Ratio   11.9%

The ratio represents the Capital adequacy ratio for the bank is 11.9%, which is pretty high number and is optimal to cover the risk it is carrying in its books for the assets it holds.

Capital adequacy ratio for State Bank of India

Let us try to understand the Capital adequacy ratio for Sate Bank of India. For calculating Capital adequacy ratio we need the numerator which is the tier 1 and tier 2 capital of the bank. We also need the denominator which is the risk associated with its assets, those risks weighted assets are Credit risk weighted assets, Market risk weighted assets and Operational risk weighted assets. The snapshot below represents the calculation of Capital adequacy ratio, with all the variables required to calculate the Capital adequacy ratio.

State Bank of India (Rs crore)
Tier 1 Capital   201488
Tier 2 Capital   50755
Total Capital   252243
Credit risk weighted assets   1573578
Market risk weighted assets   179107
Operational risk weighted assets   182585
Total Risk weighted assets   1935270
Capital Adequacy Ratio   13.0%

Capital adequacy ratio for ICICI Bank

Let us try to understand the Capital adequacy ratio for ICICI. For calculating Capital adequacy ratio we need the numerator which is the tier 1 and tier 2 capital of the bank. We also need the denominator which is the risk weighted assets. The snapshot below represents the calculation of Capital adequacy ratio, with all the variables required to calculate the Capital adequacy ratio.

ICICI Bank (Rs billion)
Tier 1 Capital   897
Tier 2 Capital   189
Total Capital   1086
Credit risk weighted assets   5266
Market risk weighted assets   420
Operational risk weighted assets   560
Total Risk weighted assets   6246
Capital Adequacy Ratio   17.4%

The ratio represents the Capital adequacy ratio for the bank is 17.4%, which is pretty high number and is optimal to cover the risk it is carrying in its books for the assets it holds. Also find below the snapshot for the company reported numbers.

Explanation of capital adequacy ratio formula

Capital adequacy is a measure to find the proportion of banks capital, with respect to the total risk weighted assets of the company. The credit risk attached to the assets depends on the entity the bank is lending loans to, for example the risk attached to a loan it is lending to the government is 0% but the amount of loan lend to the individuals are very high in percentage.  The ratio is represented in the form of a percentage, generally higher percentage implies for safety. A low ratio indicates that the bank does not have enough capital for the risk associated with its assets and it can go bust with any adverse crisis, something which happened during the recession. A very high ratio can indicate that the bank is not utilizing its capital optimally by lending to its customers. Regulators worldwide have introduced Basel 3 which requires them to maintain higher capital with respect to the risk in the books of the company, in order to protect the financial systems from another major crisis. 

Relevance and Use of capital adequacy ratio formula

Capital adequacy ratio is the capital which is set aside by the bank that acts as a cushion for the bank for the risk associated with the assets of the bank. A low ratio indicates that the bank does not have enough capital for the risk associated with its assets. Higher ratios will signal safety for the bank. Capital adequacy ratio plays a very important role in analyzing banks globally post subprime crisis. A lot of banks have been exposed and their valuation plummeted as they were not maintaining optimal amount of capital for the amount of risk they had in terms of credit, market and operational risks in their books. With the introduction of Basel 3 measure the regulators has made the requirements far more stringent from earlier Basel 2, in order to avoid one more crisis in the future. In India a lot of public sector banks have fallen short of CET 1 capital and the government has been infusing these requirements over the last few years.  

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