measure of a bank's financial strength, taking into account capital reserves for loans, investments, and certain other items off the balance sheet. In general, assets with higher credit risk require more capital in reserve than low-risk assets. The aim of risk-based capital is to: (1) encourage banks to keep a sufficient cushion of equity capital, including common stock, to support balance sheet assets; (2) include off-balance sheet items in the computation of capital adequacy; (3) eliminate disincentives to holding low-risk, liquid assets; and (4) set uniform international guidelines for bank capital adequacy in the group of ten countries.
In the United States, the risk-based capital formula raises the mandatory capital from 5.5% of assets to 8%, 4% of which must be in Tier 1 capital (common stock plus noncumulative preferred stock); and 4% in other types of qualifying capital, including loan loss reserves, perpetual preferred stock, hybrid capital instruments, such as mandatory convertible debentures, and subordinated debt.
The risk-based guidelines, approved by the Basle Committee on Banking Regulations and Supervisory Practices (the Basle Supervisors' Committee), are a fundamental change in calculation of bank capital from previous measures of calculating capital adequacy. It shifts capital determination from the liability side of the balance sheet to the asset side, using a formula that assigns specific risk weights to different groups of assets. A bank's risk-based capital ratio is computed by dividing its qualifying capital by its weighted risk assets. Assets given a 100% risk rating, such as commercial loans and consumer installment loans, require an institution to maintain total equity capital (tier 1 and tier 2 capital) equal to 8% of the asset's book value. So-called riskless assets, having a risk rating of zero (cash, U.S. government securities), require no capital held in reserve.
The risk weights for balance sheet assets are summarized as follows:
-0% risk weight: cash, gold bullion, loans guaranteed by the U.S. government, balances due from Federal Reserve Banks.
-20% risk weight: demand deposits, checks in the process of collection, risk participations in bankers' acceptances and letters of credit, and other short-term claims maturing in one year or less.
-50% risk weight: 1-4 family residential mortgages, whether owner occupied or rented; privately issued mortgage backed securities and municipal revenue bonds.
-100% risk weight: cross-border loans to non-U.S. borrowers, commercial loans, consumer loans, derivative mortgage backed securities, industrial development bonds, stripped mortgage backed securities, joint ventures, and intangibles such as interest rate contracts, currency swaps, and other derivative financial instruments.
