Capital Ratio
Capital Ratio is a measurement of the amount of regulatory capital (equity and retained earnings) that a bank must maintain relative to its risk-weighted assets. Generally, the higher the ratio, the stronger the bank’s capital position relative to its risk-weighted assets, indicating greater financial stability.
It measures the extent to which a firm has sufficient reserves (its Capital Adequacy Ratio) to cover the risk of assets declining in value, potentially leading to bankruptcy.
Under the BASEL III regulatory rules published in 2010, this coverage must at minimum equal 8% of risk-weighted assets.
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Although it applies across all businesses, it has become especially relevant to Financial Firms in recent years as a result of the 2007-09 Financial Crisis, in which banks were found to be suffering from liquidity (as distinct from solvency) issues, causing then to sharply cut back on lending, thereby exacerbating the intensity of the economic crisis.
Once the fallout of the Mortgage Crisis eased, Central Banks in the US, Europe and the UK decided to subject their domestic financial institutions to periodic “Stress Tests”.
These tests evaluate whether or not banks had enough capital to absorb hypothetical extreme economic shocks, such as a market crash, a deep recession leading to mortgage delinquencies etc, and to assess the institutions’ vulnerability to market, credit and liquidity risks.
In the UK, for example, the 2019 stress test looked at several scenarios including:
- Sterling exchange rate index falls by 28%
- Monetary policy base interest rates rise to 4%
- Household property prices fall by 33%
- Share prices fall 41%
- Start-to-trough fall in global GDP of -2.6%
- UK real GDP falls by 4.7%
- Unemployment rate rises to 9.2%
As of that date, all 7 UK Financial Institutions passed this test after taking actions to comply with its requirements, including cutting dividends, cutting employee variable compensation, reducing coupon payments, and in Lloyds and Barclays’ case, converting contingent capital into equity.
Should a financial institution fail these tests, they will be expected to provide regulators with a plan to remedy these weaknesses, which may include being forced to raise additional capital from new or existing investors.
This may not be easy and as such all banks will seek to avoid that outcome.
Some have argued that these tests set the bar too low, making it easier for these institutions to pass, but if that is the case, one can expect the markets to pass judgement, with any of them seemingly in distress seeing an increase in their costs of inter-bank funding. This is how investors were made aware of problems within the banking system in early 2007.