Definition
The capital ratio compares an institution's regulatory own funds with its total risk exposure amount, that is its risk-weighted assets (RWA). It comes in three tiers, depending on the quality of capital:
- the CET1 ratio: Common Equity Tier 1 capital over RWA;
- the Tier 1 ratio: CET1 plus Additional Tier 1 (AT1) over RWA;
- the total capital ratio: Tier 1 plus Tier 2 over RWA.
Calculation method
The numerator starts from accounting equity and applies prudential filters and deductions: goodwill, intangible assets, deferred tax assets that rely on future profitability, significant investments in financial sector entities above thresholds, among others. AT1 and Tier 2 instruments are included if they meet the eligibility criteria.
The denominator is the sum of RWA for credit, counterparty, credit valuation adjustment (CVA), market and operational risk.
Regulatory requirement
Article 92 of the CRR sets the Pillar 1 minima: 4.5% CET1, 6% Tier 1 and 8% total capital. On top come the Pillar 2 requirement (P2R) set by the supervisor after the SREP, then the combined buffer requirement: the capital conservation buffer (2.5%), the countercyclical buffer and, where applicable, systemic risk and systemically important institution buffers. The supervisor may also communicate Pillar 2 guidance (P2G).
Ratios are reported in COREP. Falling below the combined buffer requirement restricts distributions, according to the maximum distributable amount (MDA).
Practical challenges
- Explaining changes between reporting dates, between own funds and RWA effects, item by item.
- Projecting ratios over the planning horizon and under stress, as expected in the normative perspective of the ICAAP.
- Consistency between the accounting, risk and reporting data feeding the numerator and denominator.
In RIALTO
This concept is covered by the Solvency Insight Core module. The use case 'Stress simulation' shows it in practice.