Capital adequacy ratio is a formula used by financial regulators to keep track of how well-protected a bank is against risks. The principle of the ratio is to divide the bank's current capital against its current risks. In many countries, a bank's ratio must be kept at or above a certain figure.
For the purposes of this formula, the capital of a bank is classed in two tiers. As a general principle, tier 1 capital is what the bank can use immediately while still trading. Tier 2 capital is what would become available during the liquidation process if a bank closed down. As the former is more valuable, some measurements of capital adequacy ratio only take into account tier 1 capital.
The risks measured in these calculations are actually the bank's assets. This may seem confusing at first glance, but they are the risks that these assets might not be realized. For example, if a bank has lent money, it is considered an asset, but there is a risk if may not get this money back.
Most countries abide by the Basel Accords, which take their name from being determined by the Basel Committee of the Bank for International Settlements. The original 1988 accord, known as Basel I, simply required banks with an international presence to maintain a capital adequacy ratio of at least 8%. Basel II, agreed in 2004, added further rules requiring governments to check whether an individual bank's circumstances might mean it needed a higher ratio. It also required banks to be more open about the risks they were taking, the theory being that the market would then adjust its valuation of the bank's assets in light of this information.
The Basel accords have been revised over the years to take more account of how solid particular assets are. For example, a bank may have the same dollar amounts tied up in loans to its country's governments and in unsecured loans to individuals. When assessing assets and risks, the former is clearly much more valuable as it is considerably more likely that the bank will get the cash back.
To take account of this, some measurements of capital adequacy ratio will multiply each asset by a standard risk weighting. A loan to a government might be weighted at zero, meaning it is effectively ignored for risk assessment purposes. A loan to a less reliable source might be weighted at 0.75, meaning 75% of the loan's value is included in the risks figure when calculating the ratio.