How to access the financial health of your bank?

Capital is vital to a bank’s operation. Adequate capital strengthens a bank's financial capacity and provides additional buffers to ensure sufficient funds to handle daily operations in the event of an unexpected case. A good gauge on a bank's financial health and soundness is its “Capital Adequacy Ratio” (CAR). This ratio is a measure of a bank's ability to write off bad debts or non-performing loans, with a higher ratio reflecting a stronger financial position. This ratio is closely monitored by investors and regulators, due to the bank's business model. Banks earn interest spreads by lending money to borrowers with the money saved by the depositors. Banks have to bear the credit risk of the borrower who might not able to repay. In the event of bad debts, the bank will suffer from losses and be negatively impacted on the liquidity if the losses are significant. This risk can be monitored through capital adequacy ratio.

Under Basel III, Capital adequacy ratio (CAR) is a collective term for the following: Common Equity Tier 1 (CET1), Tier 1 Capital Ratio and Total Capital Ratio. The ratio is calculated by dividing the "capital base" by the "risk-weighted assets", which looks simple but the actual calculation is more complicated than expected. On the numerator, the capital base can be divided into Tier 1 and Tier 2, of which Tier 1 being further subdivided into Common Equity Tier 1 (the highest quality regulatory capital in terms of loss absorption) and Additional Tier 1 capital. Overall, Tier 1 capital comprises items such as common equity, retained earnings, paid-up capital and other reserves; while Tier 2 capital includes loan-loss reserves or undisclosed reserves, preferred shares, revaluation reserves and general provisions, as well as subordinated debt.

For the denominator "risk-weighted assets", it is a value calculated by categorizing different bank assets according to risk and multiplying them by the corresponding risk coefficients. Among bank assets, cash and treasury bills are considered as risk-free to low-risk assets with a risk factor of 0%, while speculative grade bonds and equity investments can be more than 100%. For bank loans, they are categorized according to the default risk of different customers, with weights ranging from 0% to 100% for the lowest to the highest risk loans. In other words, the higher the risk-weighted asset value, the greater the credit risk borne by the bank.

Despite the risk, there is still a strong incentive for banks to increase their risk-weighted assets in order to increase their revenue (the higher the credit risk, the higher the interest rate they charge to compensate for the potential risk a bank faces). However, under the minimum capital adequacy ratio requirement, banks have to expand their capital if they want to increase their risk-weighted assets. In summary, the capital adequacy ratio reflects the extent to which a bank is able to absorb losses with its own capital in the event of a loss. The higher the ratio, the stronger the bank's financial position. It is a good gauge for the bank’s financial health. According to the Bank of England, the total capital ratio of UK banks should not be less than 8%. As of 2023 Q4, the average total capital ratio in the UK banking sector was 21.2%. In contrast, iFAST Global Bank's total capital ratio was 36% over the same period, which is much higher than its UK counterpart.

Table 1: Average total capital ratio of the UK banking sector

Source: Bank of England