The capital ratio is the relationship between a bank's capital
and its exposure to risk
, such as default of loans. It ensures that a bank will be able to repay its cash depositors and fulfill its other obligations.
A bank makes its profits from return on capital. It enters into contractual agreements in which capital is invested or lent, and fees are collected in return for assuming risk. The risk is that the counterparty will default, in which case the capital involved may be lost, or the cash flow from the capital, the interest, will be lost. Cash, bonds, mortgages and loans are all assets to a bank, since all generate cash from risk.
For the purpose of calculating risk, however, assets must be considered differently. For example, if a homeowner defaults, the property can be reposessed and the capital at least partially recovered, but the interest payments will cease. A gilt can drop in value, but its interest will always be paid. If a loan is made to a company which subsequently goes bankrupt, there is a high probability that all capital and future cash flow will be lost. Therefore, risks are weighted accordingly. The exposure to an asset is the value of that asset multiplied by the risk weighing, expressed as a percentage. Weightings also apply to off balance sheet instruments like Interest Rate Swaps.
The Basle committee, which sets the ratio for the G10 nations, defines three types of capital, Tier 1 to Tier 3, and sets the risk weightings for different classes of assets. Tier 1 capital is shareholder equity, retained profit and certain types of preference share. Tier 2 capital is all other reserves, certain types of fixed interest instruments, and other kinds of preference share. Tier 3 includes unsecured debt instruments with a maturity greater than 2 years. A bank must meet at least half of the capital ratio required by the central bank with Tier 1 capital, and the rest with Tier 2. Lending to other banks or to governments typically requires a smaller ratio, not merely a different weighting.
For example, if the risk weighting associated with a mortgage is 40%, and a bank has £1000M of mortgages outstanding, then the risk weighted value is £400M. If the capital ratio is 10%, then the bank must have at least £20M on hand in Tier 1 capital, and if that is less than £40M the difference must be made up with Tier 2 capital, to cover that risk alone. If it does not, the central bank will force it to raise capital, for example by reducing the dividend paid to shareholders to increase retained profit.