Now that we know about capital and risk-weighted assets, let’s look at a ratio that brings these two metrics together to create the most used ratio in banking regulations.
This ratio is called capital ratio—also known as capital adequacy ratio or capital-to-risk-weighted assets ratio. Capital ratio is nothing but the ratio of capital a bank has divided by its risk-weighted assets. The capital includes both tier one and tier two capital.
This ratio indicates how much capital a bank has when compared to its risk-weighted assets. All banks must have this ratio in excess of the minimum prescribed regulatory limits for most bank. This ratio is currently at 8% for banks regulated by the Federal Reserve.
Banks such as JPMorgan (JPM), Wells Fargo (WFC), Citibank (C), Bank of America (BAC), and banks in an ETF like the Financial Select Sector SPDR Fund (XLF) have capital ratios above the regulatory requirement.
Capital ratio indicates a bank’s ability to withstand risks. Primarily, capital ratio helps a bank to withstand credit risk, liquidity risk, and operational risk. Generally, banks with high capital ratio are considered strong.
The capital ratio in the U.S. banking system increased after the subprime crisis (see the chart above) to shore up capital in the turbulent times. The ratio also increased due to the Federal Reserve giving loans to banks to help them out.