All banks in the United States must follow standards for capital management set forth by the Board of Governors of the Federal Reserve System. These standards include risk-based capital guidelines or ratios. A bank's capital risk ratio constitutes the percentage of capital the bank holds in relation to the bank's assets, weighted by risk.
The Board of Governors of the Federal Reserve System evaluate financial institutions' capital risk ratios to ensure that the banks and other depository or lending institutions maintain sufficient levels of capitalization. Other aspects of this evaluation include reviewing the financial institution's balance sheet assets, derivatives, letters of credit and unfunded loan contracts. If an institution falls below the ratios determined by this regulatory agency, the financial institution may have to pay fines, fees or other penalties set by the regulatory agency.
The Various Ratios
For a bank to meet all of the required capital risk standards, as determined by the Federal Reserve Board, the bank must demonstrate that it meets or exceeds the 4 percent tier 1 capital ratio, the 8 percent tier 2 capital ratio and the 4 percent leverage ratio. For a bank to qualify as well capitalized, the bank must show that it meets or exceeds a 6 percent tier 1 capital ratio, a 10 percent tier 2 capital ratio and a 5 percent leverage ratio. Each ratio additionally includes a subgroup of classifications.
What the Ratios Mean
The Basel 1 accord subdivides these classifications into their respective categories. The Basel Accord is a system of measuring capital that governs international banking institutions. The classifications as set forth in Basel 1 show tier 1 capital composed mainly of shareholder equity. Tier 2 capital, on the other hand, also includes undisclosed and revaluation reserves, subordinated-term debt and general provisions. Tier 2, in other words, can represent mostly supplementary capital.
Calculating the Total Risk-Based Capital Ratio
A bank determines its total risk-based capital ratio by adding its tier 1 and tier 2 capital ratios and dividing this sum by the bank's risk-weighted assets. U.S. federal regulations do not allow a bank's tier 2 capital to exceed its tier 1 capital. The justification for this regulation is that tier 1 represents permanent capital, whereas tier 2 capital represents temporary capital. As of 2011, the total risk-based capital ratio required of all banks in the United States is 8 percent.
- "Internal Credit Risk Models: Capital Allocation and Performance Measurement"; Michael K. Ong; 1999
- "Risk Management and Shareholders' Value in Banking: From Risk Measurement Models to Capital Allocation Policies"; Andrea Sironi and Andrea Resti; 2007
- "Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms, 1st Edition"; Anthony Saunders; 1999