Banks are required to be sufficiently capitalized, meaning they must have enough assets that can be readily converted to cash to meet short-term and long-term obligations. Regulators require banks to maintain two types of capital, known as Tier 1 and Tier 2 capital, to protect depositors and shareholders against unexpected losses. These regulations play an important role in the safety and liquidity of the international banking system.
Get the Tier 1 capital, which is permanent shareholders’ equity minus goodwill (an intangible asset such as a brand’s value). Permanent shareholders’ equity equals the book value of the common stock (par value plus additional amounts paid by investors) plus retained earnings (net income minus dividend payments).
Record the Tier 2 capital, which equals loan loss reserves (allowances for unpaid loans), plus subordinated debt (junior debt with a lower claim than other debt), plus hybrid debt (e.g., convertible debt that can be converted to shares), minus investments in unconsolidated financial subsidiaries (i.e., minority interests) and investments in the capital of other banks.
Add Tier 1 capital to Tier 2 capital to get the total capital. For example, if a bank’s Tier 1 and Tier 2 capital are $1 million and $1.5 million, respectively, then the total capital is $2.5 million.
Compute the risk-weighted assets, which are the bank’s different types of assets weighted according to their respective risk levels. The risk weighting for cash and government bonds is zero percent (i.e., risk-free); for mortgage loans, it is 50 percent; and for ordinary loans, it is 100 percent. In the example, if the bank holds $1 million in cash and has $4.8 million and $20 million of mortgage loans and ordinary loans outstanding, respectively, then the total risk-weighted assets are $22.4 million (1,000,000 x 0.00 + 4,800,000 x 0.50 + 20,000,000 x 1.00).
Calculate the capital ratios, which are the respective capital levels divided by the risk-weighted assets and expressed as percentages. In the example, the Tier 1 capital ratio is about 4.5 percent: (1 / 22.4) x 100; the Tier 2 capital ratio is about 6.7 percent: (1.5 / 22.4) x 100; and the total capital ratio, known as the capital adequacy ratio, is 11.2 percent (4.5 + 6.7).
Evaluate the capital ratios against the minimum regulatory requirements. In 1989, the United States adopted the minimum capital standards set by the Bank for International Settlements, based in Basel, Switzerland. The minimum Tier 1 ratio and total capital ratio requirements are 4 and 8 percent, respectively. To conclude the example, the Tier 1 capital and total capital ratios are both above the minimum requirements.