Capital adequacy ratio
What is capital adequacy ratio?
The capital adequacy ratio weighs up a bank’s capital against its risk. The calculation is shown as a percentage of a bank's risk weighted credit exposures.
This ratio ensures banks have enough capital to cover potential losses, which protects them from insolvency. The higher the ratio, the more stable and efficient the bank is and the less likely it is to become insolvent.
Where have you heard about capital adequacy ratio?
You may not have heard about the capital adequacy ratio if you are not familiar with banking regulations. However, as a bank depositor, the capital adequacy ratio protects your money by creating a buffer that aims to prevent the bank from collapsing.
What you need to know about capital adequacy ratio.
The capital adequacy ratio is calculated by the following:
Tier 1 capital + Tier 2 capital ÷ risk weighted assets
Tier 1 capital is mainly common stock which is able to absorb losses without causing the bank to collapse. Tier 2 capital includes undisclosed reserves, hybrid instruments and revaluation reserves which is less reliable but can to a lesser extent also absorb losses.
The percent threshold for a bank’s capital adequacy ratio is set by the national banking regulator, although many follow the requirements set by the Basel Committee, which is the primary global standard setter for banking regulations. This currently stands at 9% under Basel III.
This threshold maintains banks’ stability by ensuring they do not increase the risk of insolvency by building too much leverage.
Find out more about capital adequacy ratio.
Learn more about the different types of capital with our definition.