Risk-Adjusted Capital Ratio
a ratio used to measure a financial institution's ability to continue functioning in unfavorable events such as an economic recession.
Risk-Adjusted Capital Ratio Details
The credit rating agency Standard & Poor's (S&P) introduced the Risk-Adjusted Capital Ratio in 2009 provides an accurate assessment of capital sufficiency and help maintain consistency across ratings.
S&P intended to introduce a more risk-sensitive ratio than what the financial industry had worked with (e.g., leverage ratio) and that would be independent of banks' risk assessments.
S&P designed the then-new ratio to capture a range of risks. These risks cover credit risk, trading risk, equity risk, operational risk, and concentration risk.
Example of Risk-Adjusted Capital Ratio
Financial institutions calculate Risk-Adjusted Capital Ratio by dividing total adjusted capital by risk-weighted assets (RWA). The total adjusted capital equals the sum of equity instruments and the instruments a company can convert to equity. Furthermore, banks calculate risk-weighted assets by multiplying the exposure, which represents the initially invested funds that an investor may lose, by the relevant risk weight that the asset carries. Intuitively, tangible assets such as coins aren't risky, while credits carry a high risk.
Banks do this calculation for all of their loans and assets, and finally, by adding them together, calculate total credit risk-weighted assets. Say your company's cash equals $5,000, but you have bought municipal bonds equalling $150,000 and you have lent $300,000 to foreign banks. Your cash would be risk-free and if the bonds and the loans carry 20% risk, the risk-weighted assets would equal $95,000. If your assets minus your liabilities equal $500,000, you should divide it by $95,000 to receive the risk-adjusted capital ratio equalling 5.26.
Risk-Adjusted Capital Ratio vs. the Basel II Standardized Approach
When S&P launched the ratio, the agency announced that its risk weightings would be more risk-sensitive than the Basel II standardized approach. The Basel II approach demands that all financial institutions set money aside for operational risks, undergo a supervisory review process, and make market discipline disclosures. In addition, the agency said that case studies from 150 banks suggest that the global banking system would be weakly subsidized in case of a crisis in its existing risk-adjusted capital structure.
S&P calculated the RAC ratio average for the 150 banks to be a little over 7% and equaling 5.5% for the largest 20 banks.
After spreading out the concentration and diversifying, the RAC ratio was on average 30% lower than the Basel II Tier 1 ratio. Here, it's important to distinguish between Tier 1 capital, which includes disclosed assets, and Tier 2 capital, which doesn't appear on the financial statements. In addition, in the United States, the RAC ratio turns out to be significantly lower on average than the regulatory ratio (the capital requirement).
Significance of Risk-Adjusted Capital Ratio
In connection to the COVID-19 crisis, S&P Global Ratings released a report stating that large European banks suffer a decline in their average risk-adjusted capital ratio. This ratio quantifies their ability to continue functioning in the event of an economic plunge in the next two years.
The rating agency said it expects the pandemic's economic impact to affect the average RAC ratio for the top 50 European banks. S&P global ratings estimate the RAC to come in at 10.1% in 2020-2021, down 30 basis points from 10.4% in 2019, because of the expected asset quality, revenue deterioration, and lengthened low-interest rates.
S&P Global Ratings said its projections consider its expectations of a sharp rise in loan loss provisions and a decline in asset quality, resulting in significantly reduced earnings for nearly all the banks.