Introduction to Finance

Risk-Weight (%)
Cash and equivalents
0%
Government securities
0
Interbank loans
20
Mortgage loans
50
Ordinary loans
100
Standby letters of credit
100
Two capital ratios (tier 1 and total capital) are calculated using risk-adjusted assets. They 
are defi ned as follows:
Tier 1 ratio =
Tier 1 capital
Risk-adjusted assets
× 100 (3.4)
Total capital ratio =
Tier 1 + Tier 2 capital
Risk-adjusted assets
× 100 (3.5)
Let’s assume that a bank has common equity of $3.0 million, no noncumulative preferred 
stock, trust-preferred securities of $.5 million, and a $1 million loan-loss reserve account. 
Intangible assets (goodwill) amount to $1.5 million. In terms of other assets: cash and equivalents = 
$1 million; government securities = $2 million; interbank loans = $5 million; mortgage 
loans = $20 million; ordinary loans = $18 million; and standby letters of credit = $2 million. 
Tier 1 capital = $3 million in common equity + $.5 million in trust-preferred securities – 
$1.5 million in intangible assets, or $2 million. Total capital = tier 1 capital of $2.0 million + 
$1.0 million in loan-loss reserves, or $3.0 million. Risk-adjusted assets are,
Cash and equivalents
=
$1 million
×
.00
=
$0 million
Government securities
=
$2 million
×
.00 
=
$0 million
Interbank loans
=
$5 million
×
.20
=
$1 million
Mortgage loans
=
$20 million
×
.50
=
$10 million
Ordinary loans
=
$18 million
×
1.00
=
$18 million
Standby letters of credit
=
$2 million
×
1.00
=
$2 million 
Risk-adjusted assets
=
$31 million
The tier 1 and total capital ratios are calculated as follows:
Tier 1 ratio =
$2.0 million
$31 million
× 100 = .0645 × 100 = 6.45 %
Total capital ratio =
$3.0 million
$31 million
× 100 = .0968 × 100 = 9.68 %

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3.9 International Banking and Foreign Systems
71
To be considered “adequately capitalized,” a bank needs to have a 6 percent tier 1 capital 
ratio and an 8 percent total capital (tier 1 plus tier 2) ratio. The bank in our example surpassed 
both capital adequacy hurdles with a tier 1 ratio of 6.45 percent and a total capital ratio of 
9.68 percent.
There is a strong incentive for bank managers to meet minimum capital ratio require-
ments. Banks that are classifi ed as being undercapitalized by the FDIC must submit plans to 
the FDIC indicating how they intend to become adequately capitalized. Signifi cantly under-
capitalized banks may be required to replace their managers and even their board of directors, 
as well as restructure their balance sheets. Critically undercapitalized banks must restructure 
and may even be seized by the FDIC.
The 2007–08 fi nancial crisis impacted many countries throughout the world causing 
great concern that the international fi nancial system might collapse. Underperforming 
mortgages and mortgage-related securities soon became referred to as “troubled” or “toxic 
assets.” Banks and other holders of these securities were forced to “write down” the values of 
these assets to refl ect their new market values. This, in turn, reduced their bank capital ratios 
to unacceptable levels. 
As a result, global banking regulators passed Basel III in late 2010 requiring banks 
throughout the world to keep much larger capital reserves to protect against possible losses. 
Also, passage of the Dodd-Frank Act in 2010 impacts how risk-adjustments to bank assets are 
to be made for use in ratio calculations. While further rule changes are likely, regulators con-
tinue to focus on reducing the likelihood of bank failures in the United States and throughout 
the world by implementing higher capital minimum requirements on banks.