Posts Tagged ‘Bank Capital Ratios’

Capital Ratios of Financial Institutions

Thursday, August 14th, 2008

With the stocks of banks and investment banks imploding in 2008, there’s been much talk of capital ratios.  Regulators require banks to maintain minimum capital requirements.  The reason is to prevent them from failing due to overzealous lending during economic expansions that could result in financial setbacks when the economy turns down.  So just what are capital ratios?

In the United States, there are two primary capital ratios:  Tier 1 and Tier 2.  The Tier 1 capital ratio is the most important one, and that’s what I’ll focus on here.

The Tier 1 capital ratio consists of the ratios of the bank’s stockholders’ equity, preferred stock and retained earnings to its total risk-weighted assets.  Risk-weighted assets are calculated by putting each of the bank’s assets and off-balance sheet items into a basket and assigning a risk category to that basket.  Risk categories range from 0% to 100%.  If the overall risk is lower, then the bank is considered more stable for depositors and more conservative for investors.

The problem today is in determining both the valuation of and the risk relative to the assets.  Some, as I noted in my earlier posting on auction rate securities, are hard to value, but are less likely to default.  Others, such are a letter of credit, may be considerably riskier.  So actually determining the Tier 1 capital ratio involves art as well as science. Thus, bank stocks, which have fallen considerably this year, may still be overvalued.

Regulators use the Tier 1 capital ratio to segregate banks into five categories ranging from well-capitalized  to critically undercapitalized.

The Tier 2 capital ratio includes undisclosed reserves, general loss reserves, subordinated term debt, hybrid instruments, among other items.

Title 12 of the Code of Federal Regulations includes the regulations regarding minimum capital ratios.  A much more detailed compendium of what is included in bank capital ratios is available in Appendix A to Part 3.