How Is Capital Adequacy of a Bank Measured?

The capital adequacy of banks is tightly regulated worldwide in order to better ensure the stability of the financial system and the global economy. It also provides additional protection for depositors. In the United States, banks are regulated at the federal level by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board and the Office of the Comptroller of the Currency (OCC). Additionally, state-chartered banks are subject to state regulatory authorities. Regulation and solvency of banks is considered to be critical because of the unique importance of the banking industry to the functioning of the economy as a whole.

Monitoring the financial condition of banks is also important because banks have to deal with a mismatch in liquidity between their assets and liabilities. On the liabilities side of a bank's balance sheet are very liquid accounts, such as demand deposits. However, a bank's assets primarily consist of rather illiquid loans. While loans can be (and frequently are) sold by banks, they can only quickly be converted to cash by selling them at a substantial discount.

The most commonly used assessment of a bank's capital adequacy is the capital adequacy ratio. However, many analysts and banking industry professionals prefer the economic capital measure. Additionally, analysts or investors may look at the Tier 1 leverage ratio or basic liquidity ratios when examining a bank's financial health.

Capital Adequacy Ratio

U.S. banks are required to maintain a minimum capital adequacy ratio. The capital adequacy ratio represents the risk-weighted credit exposure of a bank.

The ratio measures two kinds of capital: 

1. Tier 1 capital is ordinary share capital that can absorb losses without requiring the bank to cease operations.
2. Tier 2 capital is subordinated debt, which can absorb losses in the event of a winding up of a bank.

Some analysts are critical of the risk-weighting aspect of the capital adequacy ratio and have pointed out that the majority of loan defaults that occurred during the financial crisis of 2008 were on loans assigned a very low-risk weighting, while many loans carrying the heaviest weighting for risk did not default.

Tier 1 Leverage Ratio

A related capital adequacy ratio sometimes considered is the Tier 1 leverage ratio. The Tier 1 leverage ratio is the relationship between a bank's core capital and its total assets. It is calculated by dividing Tier 1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures.

The higher the Tier 1 leverage ratio is, the more likely a bank can withstand negative shocks to its balance sheet.

Economic Capital Measure

Many analysts and bank executives consider the economic capital measure to be a more accurate and reliable assessment of a bank's financial soundness and risk exposure than the capital adequacy ratio.

The calculation of economic capital, which estimates the amount of capital a bank needs to have on hand to ensure its ability to handle its current outstanding risk, is based on the bank's financial health, credit rating, expected losses and confidence level of solvency. By including such economic realities as expected losses, this measure is considered to represent a more realistic appraisal of a bank's actual financial health and risk level.

Liquidity Ratios

Investors or market analysts can also examine banks by using standard equity evaluations that assess the financial health of companies in any industry. These alternative evaluation metrics include liquidity ratios such as the current ratio, the cash ratio or the quick ratio.