Accounting question : How to calculate the Capital Adequacy Ratio?

Question

Ilustrate with a few examples where :
a) Capital Adequacy ratio is low
b) Capital Adequacy ratio is high
c) Capital Adequacy ratio is standard/normal.

Answer 1

Calculation of ratios, as well as conclusions about capital adequacy, can get very complicated. These calculations get much more difficult with larger and more complicated banks. In this discussion, the calculation of the ratios uses the more common capital items found in smaller banks. A more detailed discussion of capital adequacy can be found in Section 3020.1 of the Federal Reserve System’s Commercial Bank Examination Manual. More information can also be found on ratio components and calculations by going to the most current version of the FFIEC’s Call Report instructions and checking instructions for Schedule RCR or the glossary.

The tier 1 risk-based capital ratio (tier 1 CAR) is tier 1 capital divided by risk-weighted assets. Tier 1 capital is the sum of core capital elements (capital stock, surplus, undivided profits, qualifying noncumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries) less goodwill and other intangible assets. Tier 1 capital does not include any gains or losses on available-for-sale securities. For most community banks, tier 1 capital is simply capital stock, surplus and undivided profits.

Risk-weighted assets are calculated by assigning each asset and off-balance-sheet item to one of four broad risk categories. These categories are assigned risk weights of 0 percent, 20 percent, 50 percent, and 100 percent. Riskier assets are placed in the higher percentage categories. For example, the 0 percent category includes cash and U.S. Treasury securities, while loans are generally in the 100 percent category. Risk-weighted assets, tier 1 capital, tier 2 capital and all three of the aforementioned capital ratios (tier 1 leverage, tier 1 risk-based and total risk-based) are also included in your bank’s quarterly Call Report.

Banks are expected to meet a minimum tier 1 risk-based capital ratio of 4 percent.

The total risk-based capital ratio (total CAR) is the sum of tier 1 and tier 2 capital divided by risk-weighted assets. Tier 2 capital is the sum of the allowance for loan and lease losses (limited to 1.25 percent of risk-weighted assets), perpetual preferred stock not qualifying as tier 1 capital, subordinated debt and intermediate term preferred stock. Tier 2 capital cannot exceed tier 1 capital. For most community banks, tier 2 capital is simply the allowance for loan and lease losses (limited to 1.25 percent of risk-weighted assets).

Banks are expected to meet a minimum total risk-based capital ratio of 8 percent.

A Note About Minimum Ratio Values

Because risk-based capital ratios do not take explicit account of the quality of individual asset portfolios or of other types of risk to which a bank may be exposed (including interest rate, liquidity, market and operational risks), banks are generally expected to operate with positions above the minimums. In determining capital adequacy, various risks and exposures need to be taken into account:

Higher-risk banks, in particular, should maintain capital well above the minimums. Higher-risk banks include those growing aggressively as well as those with weaker asset quality, earnings or management.
Large exposures from litigation or from off-balance-sheet items also require additional capital.
It also may be helpful to compare your bank’s ratios with those of a peer bank. If your bank compares unfavorably with its peer in terms of earnings or past-dues and nonaccruals, you likely need to have higher capital ratios. Similarly, if your bank is growing faster than its peer, you likely need higher capital ratios than the peer bank. The word “likely” is used here because there could be mitigating factors at your individual bank or because a peer bank could be a poor example for your bank to follow. At some point, this can become a judgment call, and the exact point at which a bank becomes less than adequately capitalized can also be a judgment call. At any rate, your bank’s comparison with a peer bank is useful information, and consideration of trends (in capital and asset growth, earnings or asset quality, for example) can also be helpful. Also, if your bank is experiencing a downward trend in capital ratios, as a director you should work with executive management to develop a plan to restore capital before the downward trend gets out of hand.
The tier 1 leverage ratio is tier 1 capital divided by average total consolidated assets. Average total consolidated assets equals quarterly average assets from a bank's most recent Call Report less goodwill and other intangible assets.

The minimum tier 1 leverage ratio is 4 percent, unless the bank is highly rated by its supervisors. Again, this is just a minimum, and banks—especially higher-risk banks—should operate with a leverage ratio above the minimum.

Answer 2

Calculation Of Capital Adequacy Ratio