Banks & Risk Adjusted Capital Adequacy Ratio?

Question

Banks & Risk Adjusted Capital Adequacy Ratio?

Answer 1

A Bank has Assets and Liabilities. Different assets are of different degrees of risk in terms their probabilty to turn bad and the extent to which the value of the assets that can be realised. For examples borrowers may deafult in paying their loans back to the bank along with interest simply because the borrower may face huge losses and may even become insolvent. Or, the value of investments made by the bank may show a deprecation because of the fall in their prices in the stock market or other financial assets markets. Thus, the different classes of assets have different risk weights. The value of the assets as shown the balance sheet of a bank are multiplies with their corresponding weights (varying for zero for risk-free assets like cash to 1 or more than 1) and then added up to arrive at the bank's Risk Adjusted Asset size in moneytary terms. Let this be denoted by RAA.

The bank normally have many different kinds of liabilities like Deposit, borrowing agaist collateral/ security like secured bonds, unsecured long-term bonds issued to the public or institutional borrowers and the shareholdrs' funds (share capital plus internal accruals), etc. Of this, the shareholders funds plus the long-term quasi equty or unsecured bonds on the liabilities side of the bank's balance sheet together form the capital of the bank. Let this be denoted by C.

Now, the Risk weighted Capital adequacy ratio is given by RAA divided by C.

Higher this ratio is better for the depositors because the incdence  assets really turning bad will be first on the shareholders of the bank and its unsecured quasi-equity and bond investors. Lower this ratio, the risk to the depositors of the bank unable to return their money becomes higher. From the banks point of view the lower the ration better it is because they can earn more for the shareholders by growing depsits. loans and investments.

Now central banks have imposed a minimum rish weighted capital adequacy to be maintainde by the banks at 9% or higher upto 12 %. If any bank fails to satisfy the ratio, it must raise more equity or semi-equity funds to carry on its business of banking.