Adjusted capital ratio

What Is Adjusted Capital Ratio?

The adjusted capital ratio is a key metric in the realm of financial regulation and [banking supervision], reflecting a bank's capital strength after various adjustments mandated by regulatory frameworks. These adjustments aim to refine the calculation of a bank's capital against its risk-weighted assets to provide a more accurate and conservative assessment of its ability to absorb losses. The concept of an adjusted capital ratio is central to ensuring financial stability within the global banking sector.

History and Origin

The evolution of the adjusted capital ratio is deeply intertwined with international efforts to strengthen the banking system, particularly in response to financial crises. Prior to the late 20th century, bank capital adequacy was often assessed on a case-by-case basis. However, concerns about the capital positions of global banks and the desire for a level playing field led to the development of uniform capital standards in the 1980s¹¹.

The most significant developments stemmed from the Basel Accords, a series of international agreements issued by the Basel Committee on Banking Supervision (BCBS). Following the 2007–2008 financial crisis, the BCBS introduced Basel III in November 2010. This comprehensive framework was designed to improve the banking sector's ability to absorb shocks and reduce the risk of spillovers from the financial sector to the real economy. ⁸, ⁹, ¹⁰Basel III significantly enhanced the quality and quantity of regulatory capital, placing a greater focus on high-quality capital like Common Equity Tier 1 capital and revising how risk-weighted assets are calculated. These revisions and new requirements effectively introduced the concept of an "adjusted" capital ratio, as banks had to adjust their reported capital and asset risk calculations to meet the new, more stringent international standards.
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Key Takeaways

• An adjusted capital ratio provides a more stringent and conservative measure of a bank's financial health.
• It incorporates regulatory adjustments to both the numerator (capital) and denominator (risk-weighted assets) of traditional capital ratios.
• The adjustments are typically driven by international accords like Basel III and national regulatory bodies to enhance resilience.
• A higher adjusted capital ratio generally indicates a bank's greater capacity to absorb unexpected losses and maintain solvency.
• Regulators use the adjusted capital ratio to impose specific capital requirements on banks, influencing their operations and lending activities.

Formula and Calculation

While there isn't a single universal "adjusted capital ratio" formula, the concept refers to how regulatory bodies mandate specific adjustments to the components of a bank's capital adequacy calculation. The primary goal is to ensure that the reported capital truly reflects loss-absorbing capacity and that risks are appropriately captured.

A core capital ratio, such as the Common Equity Tier 1 (CET1) capital ratio, is typically calculated as:

The "adjusted" aspect comes from the detailed regulatory rules that dictate:

• Adjustments to Common Equity Tier 1 Capital (Numerator): Regulators require deductions from a bank's reported balance sheet equity for certain intangible assets (e.g., goodwill), deferred tax assets, and investments in other financial entities. The aim is to ensure that only the highest quality, truly loss-absorbing capital is counted.
• Adjustments to Risk-Weighted Assets (Denominator): This involves applying specific risk weights to different asset classes based on their perceived credit, market, and operational risks. For example, loans to highly-rated governments might have a lower risk weight than corporate loans or complex derivatives. Post-crisis reforms like Basel III also introduced more granular and stringent methods for calculating these risk weights, often limiting the use of internal models and increasing capital for certain activities like trading.
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  These adjustments ensure that the capital ratio reflects a bank's true vulnerability to potential losses, leading to a more robust measure than a simple book value comparison.

Interpreting the Adjusted Capital Ratio

Interpreting the adjusted capital ratio involves understanding its primary purpose: safeguarding the banking system and, by extension, the broader economy. A higher adjusted capital ratio indicates that a bank has a larger buffer of high-quality capital relative to its risks, making it more resilient to economic downturns or unforeseen losses.

Regulatory bodies, such as the Federal Reserve in the United States, set minimum adjusted capital ratio requirements that banks must meet to operate. These requirements often include a minimum Common Equity Tier 1 capital ratio, a capital conservation buffer, and, for the largest and most complex institutions, a stress capital buffer and a surcharge for global systemically important banks (G-SIBs). ⁴Failing to meet these adjusted capital ratio requirements can lead to restrictions on a bank's operations, including limitations on dividends, share buybacks, and discretionary bonuses. Therefore, analysts and investors monitor these ratios closely to assess a bank's financial health and its capacity for future growth and distributions.

Hypothetical Example

Consider "Horizon Bank," a hypothetical institution subject to stringent capital regulations. In its initial assessment, Horizon Bank calculates its Tier 1 capital at $10 billion and its total assets at $200 billion. However, under the adjusted capital ratio framework, regulators require several deductions and re-evaluations.

First, Horizon Bank must deduct $500 million in goodwill and another $200 million in deferred tax assets from its Tier 1 capital, as these are not considered truly loss-absorbing. This reduces its adjusted Tier 1 capital to $9.3 billion.

Next, for its risk-weighted assets, the bank's initial calculation of $100 billion in risk-weighted assets is re-evaluated. Under new rules, its portfolio of corporate loans is deemed to carry a higher risk weight, increasing their contribution to risk-weighted assets by $5 billion. Additionally, a portion of its trading book is re-assessed, adding another $2 billion in risk-weighted assets. This brings Horizon Bank's adjusted risk-weighted assets to $107 billion.

The adjusted capital ratio for Horizon Bank would then be:

This adjusted capital ratio of 8.69% is then compared against the minimum regulatory thresholds and any additional capital buffer requirements. This process ensures a more realistic portrayal of the bank's resilience.

Practical Applications

The adjusted capital ratio is a fundamental concept in several practical areas of finance and regulation:

• Regulatory Compliance: National and international banking regulators use the adjusted capital ratio to enforce minimum capital adequacy standards. For instance, the Federal Reserve Board sets specific common equity Tier 1 capital ratio requirements for large banks, incorporating components like the stress capital buffer. ³These requirements ensure that banks hold sufficient capital to withstand adverse economic conditions.
• Risk Management: Banks internally use adjusted capital ratios to evaluate their exposure to various risks, including credit risk, market risk, and operational risk. By understanding how different assets and activities impact their risk-weighted assets and capital deductions, banks can make informed decisions about their loan portfolios, investment strategies, and overall balance sheet management.
• Investor Analysis: Investors and analysts scrutinize a bank's adjusted capital ratios to gauge its financial strength, safety, and soundness. A bank with a robust adjusted capital ratio is generally perceived as less risky, potentially leading to lower borrowing costs and greater investor confidence.
• Macroprudential Policy: Central banks and supervisory authorities utilize the framework of adjusted capital ratios as a tool for macroprudential policy. By adjusting capital requirements across the banking system, they can help mitigate systemic risk and prevent the build-up of excessive leverage during periods of economic expansion, thus promoting overall financial stability.
• Mergers and Acquisitions: During mergers and acquisitions in the banking sector, the adjusted capital ratios of the involved entities are thoroughly assessed. Strong capital positions can facilitate regulatory approval and streamline integration processes, whereas weak ratios might necessitate capital injections or asset divestitures.

Limitations and Criticisms

While the concept of an adjusted capital ratio aims to enhance financial stability, it is not without limitations and criticisms.

One common critique revolves around the complexity and potential for regulatory arbitrage. The detailed rules for calculating risk-weighted assets and capital deductions can be highly intricate, allowing banks to potentially structure transactions in ways that minimize their reported risk-weighted assets without necessarily reducing their actual risk exposure. This complexity can also make it difficult for external parties to compare banks accurately.

Another point of contention is the impact of higher adjusted capital requirements on lending and economic growth. Critics argue that more stringent capital rules can force banks to hold more capital idly, reducing their capacity to lend to businesses and consumers. This can potentially increase the cost of credit and constrain economic activity. ²Some also suggest that such regulations might push financial activities into less regulated "shadow banking" sectors, creating new systemic risks outside the traditional banking system.

Furthermore, the methodologies for calculating risk-weighted assets, even with adjustments, may not fully capture all types of risk. For instance, while focusing on traditional financial risks, the frameworks might be less adept at assessing emerging risks like cyber risk or climate-related financial risks. The effectiveness of stress tests, which inform some capital adjustments, also depends on the scenarios chosen and might not account for all unforeseen market shocks.

Adjusted Capital Ratio vs. Leverage Ratio

The adjusted capital ratio, often represented by the Common Equity Tier 1 (CET1) ratio or similar risk-based measures, focuses on a bank's capital strength relative to its risk-weighted assets. This means that the denominator of the ratio differentiates between assets based on their perceived risk, assigning lower risk weights to safer assets and higher risk weights to riskier ones. The purpose is to ensure that a bank holds more capital against its riskier exposures.

In contrast, the leverage ratio is a simpler, non-risk-based measure that compares a bank's Tier 1 capital to its total non-risk-weighted assets. It provides a backstop to the risk-based adjusted capital ratios. Unlike the adjusted capital ratio, the leverage ratio treats all assets equally, regardless of their inherent risk. For example, a U.S. Treasury bond and a high-yield corporate loan would carry the same weight in the leverage ratio calculation, but vastly different weights in the adjusted capital ratio's risk-weighted assets. The leverage ratio is designed to constrain excessive leverage in the banking system and prevent banks from growing their assets too quickly without sufficient capital, even if those assets are considered low-risk by the risk-based framework.
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FAQs

Why are capital ratios "adjusted"?

Capital ratios are "adjusted" by regulators to ensure that they provide a more accurate and conservative measure of a bank's ability to absorb losses. These adjustments involve deducting certain items from a bank's reported capital (like intangible assets) and applying specific risk weightings to its assets, aiming to truly reflect loss-absorbing capacity and the actual risks undertaken.

Who enforces adjusted capital ratio requirements?

In the United States, federal bank regulatory agencies such as the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) enforce adjusted capital ratio requirements. Internationally, these standards are largely developed by the Basel Committee on Banking Supervision (BCBS) and then implemented by national regulators.

What happens if a bank fails to meet its adjusted capital ratio?

If a bank fails to meet its adjusted capital ratio requirements, regulators can impose various restrictions. These may include limitations on dividend payments to shareholders, restrictions on executive bonuses, and prohibitions on share repurchases. In severe cases, regulatory intervention can escalate to require capital injections, asset sales, or even the closure of the institution to protect depositors and maintain financial stability.

How does the adjusted capital ratio affect consumers and businesses?

The adjusted capital ratio indirectly affects consumers and businesses by influencing bank lending behavior. When capital requirements are increased, banks may become more cautious in their lending, potentially leading to tighter credit conditions or higher borrowing costs for loans. Conversely, a well-capitalized banking system, as indicated by healthy adjusted capital ratios, is generally more resilient during economic downturns, allowing banks to continue providing essential financial services.

Is the adjusted capital ratio the same for all banks?

No, the adjusted capital ratio requirements are not the same for all banks. While there are minimum international standards set by frameworks like Basel III, national regulators often tailor these requirements based on a bank's size, complexity, and systemic risk profile. For instance, global systemically important banks (G-SIBs) typically face higher capital surcharges and more stringent adjusted capital ratio requirements due to their potential impact on the wider financial system.