What it means
The idea behind risk weighting is that a dollar lent to a national government and a dollar lent to a start up are not equally dangerous, so requiring the same capital against both would be crude. Each exposure is multiplied by a weighting, commonly 0% for cash and high grade government debt, 50% for residential mortgages and 100% for ordinary corporate lending.
Capital itself is split into tiers by quality. Tier 1 is the reliable core of ordinary shares and retained profits that absorbs losses while the bank keeps trading, while Tier 2 includes subordinated debt and other items that only help once the bank is being wound up.
Supervisors set minimums, usually a total ratio somewhere around 8% plus buffers that lift the practical floor to roughly 10.5% or higher for larger institutions. Falling below the buffer does not close a bank, but it typically stops dividends and bonuses until the position is rebuilt.
Because the denominator responds to risk, the ratio changes the economics of lending. Shifting $100,000,000 from corporate loans to residential mortgages halves the risk weighted assets that lending creates, freeing capital without shrinking the balance sheet at all.
The best known criticism is that risk weights are partly model driven, so a bank can improve the ratio by changing its assumptions rather than its risks. That is precisely why the simpler capital to assets ratio was reintroduced as a backstop alongside it.
In practice
Real-world examples.
Example
A mid sized bank reports a ratio of 14.2% and uses the surplus to justify a share buyback to its investors. The supervisor accepts the distribution because the buffer remains comfortable under a stressed scenario.
Example
A lender wanting to grow without raising equity rebalances its book towards insured mortgages weighted at 35% and away from unsecured small business loans weighted at 100%. Risk weighted assets fall even as total lending rises slightly.
Example
During a downturn a bank's corporate borrowers are downgraded, which pushes some exposures into higher weightings. Risk weighted assets climb by 9% with no new lending at all, and the ratio falls below the level at which dividends are permitted.
Think of it
“Capital to risk assets compares capital to the riskiness of assets-more risk needs more capital.
Formula
Calculation
Capital to risk assets ratio = (Tier 1 capital + Tier 2 capital) / risk weighted assets x 100
A bank holds three exposures: $4,000,000,000 of residential mortgages weighted at 50%, $5,000,000,000 of corporate loans weighted at 100%, and $1,500,000,000 of government bonds weighted at 0%. It also has $1,000,000,000 of off balance sheet commitments treated at 100%.
Risk weighted assets = ($4,000,000,000 x 0.50) + ($5,000,000,000 x 1.00) + ($1,500,000,000 x 0) + ($1,000,000,000 x 1.00) = $2,000,000,000 + $5,000,000,000 + $0 + $1,000,000,000 = $8,000,000,000.
Capital is $700,000,000 of Tier 1 plus $300,000,000 of Tier 2, giving $1,000,000,000. The ratio is $1,000,000,000 / $8,000,000,000 = 0.125, or 12.5%. Against a required 10.5%, the bank must hold $8,000,000,000 x 0.105 = $840,000,000, so it has surplus capital of $1,000,000,000 - $840,000,000 = $160,000,000.Case study
Seen in the real world.
This fictional and illustrative account concerns Tarnwood Commercial Bank, an invented lender with a heavy concentration in property development finance. Its capital to risk assets ratio sat at 12.5% and looked adequate, but nearly all of its exposures carried a 100% weighting and its Tier 2 capital made up a third of the total.
In the illustrative stress test, a 6% fall in development values produced losses that fell almost entirely on Tier 1 capital, since Tier 2 instruments only absorb losses in a wind up. The invented supervisor concluded that the headline ratio overstated Tarnwood's genuine resilience and required it to raise $150,000,000 of ordinary shares.
The fictional outcome was a lower headline growth rate but a far more durable balance sheet. The story shows why the split between Tier 1 and Tier 2 matters as much as the total percentage does.
Watch out
Common mistakes.
- Comparing the ratio between banks without checking the mix of Tier 1 and Tier 2 capital, since two banks at 12% can have very different loss absorbing power.
- Assuming risk weights are objective facts, when large banks use internal models that make the weights partly a matter of assumption.
- Reading a fall in the ratio as evidence of losses, when it can equally reflect growth in lending or downgrades of existing borrowers.
Questions
People also ask.
Is this the same as the capital adequacy ratio?
Yes, the two names describe the same measure, and it is also written as the CRAR in several markets.
Why not simply require capital against total assets?
Because that ignores whether a bank lends to governments or to speculative ventures, so both measures are now used together.
What happens if a bank breaches the requirement?
Typically it faces restrictions on dividends, buybacks and bonuses, and must submit a plan to rebuild capital rather than being closed immediately.
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