Capital Adequacy Analysis is a key measure of a bank's financial strength and stability. It indicates how well a bank can absorb losses and meet its obligations to depositors and creditors. One of the main ways to assess capital adequacy is by using ratios that compare different types of capital to risk-weighted assets (RWA).
RWA are the total assets of a bank adjusted for their risk level. The higher the risk of an asset, the higher its weight in the calculation of RWA. For example, cash has a zero weight, while loans have different weights depending on their credit quality, maturity, and collateral.
Three main capital ratios are used to measure capital adequacy:
- Common Equity Tier 1 (CET1) ratio: This is the ratio of CET1 capital to RWA:
CET1 capital is the highest quality and most liquid form of capital. It consists of common shares, retained earnings, and other comprehensive income. The minimum CET1 ratio required by Basel III, the global regulatory framework for banks, is 4.5%.
- Tier 1 Capital (T1) ratio:
This is the ratio of T1 capital to RWA. T1 capital includes CET1 capital plus additional T1 capital, which is a lower quality but still relatively liquid form of capital. It consists of non-cumulative preferred shares and some types of hybrid securities. The minimum T1 ratio required by Basel III is 6.0%.
- Total Capital ratio:
This is the ratio of Total Capital to RWA. Total Capital includes T1 capital plus Tier 2 (T2) capital, which is a lower quality and less liquid form of capital. It consists of subordinated debt, cumulative preferred shares, and some types of hybrid securities. The minimum Total Capital ratio required by Basel III is 8%.
These ratios are important indicators of a bank's solvency and ability to withstand financial shocks. A higher ratio means that a bank has more capital relative to its risk exposure, which reduces the likelihood of insolvency or regulatory intervention. A lower ratio means that a bank has less capital relative to its risk exposure, which increases the probability of insolvency or regulatory intervention.