The capital adequacy ratio measures the ability of a financial institution to meet its obligations by comparing its capital to its assets. Regulatory authorities monitor this ratio to see if any financial institutions are at risk of failure. The intent behind their monitoring is to protect the financial system from the negative effects of any banking failures.
The calculation of the capital adequacy ratio is:
(Tier 1 capital + Tier 2 capital) ÷ Risk-weighted assets
The numerator of the calculation includes tier 1 and tier 2 capital. Tier 1 capital can be used to absorb losses without a financial institution having to stop its operations. Tier 2 capital can be accessed by shutting down operations and selling off assets, which is a more extreme type of security against risk.
The tier 1 capital noted in the numerator includes ordinary share capital, audited revenue reserves, future tax benefits, and intangible assets. The tier 2 capital noted in the numerator includes unaudited retained earnings, general provisions for bad debts, revaluation reserves, perpetual subordinated debt, perpetual cumulative preference shares, and subordinated debt.
When this ratio is high, it indicates that a financial institution has an adequate amount of capital to deal with unexpected losses. When the ratio is low, an entity is at a higher risk of failure, and so may be required by the regulatory authorities to add more capital.