Capital adequacy – the adequate amount (usually defined by regulators) of capital (shareholder money) a bank needs to hold, as a percentage of its risk-weighted assets.

For example, a EUR 1 000 000 mortgage would be relatively low risk, so its risk-weight might be 35%, or EUR 350 000. Thus the amount of capital the bank needs to hold for it is EUR 28 000 (8% – the minimum capital adequacy ratio, or CAR, set forth by the Basel committee).

Leverage ratio – while capital adequacy ratio considers the ratio of risk-weighted assets (mainly loans) to capital, leverage ratio takes the available capital and divides it by the total assets.

Using the above example, to hand out the EUR 1 000 000 mortgage, under Basel III rules, the leverage ratio must be greater than 3%, thus the bank needs to have EUR 30 000 worth of capital.

Ahh, Switzerland – the land of cheese, chocolate, and… banking regulation? While you may not associate the alpine nation with strict rules on financial institutions, if you come across speakers of Financese, you will hear about the Basel committee.

From what we gather, the Basel rules are the agreed way of doing things. What things, you might ask? Risk management things mostly: measuring capital adequacy, leverage ratios, etc.

To help us sort out everything, we are joined once again on ‘A Dictionary of Finance’  podcast by Vincent Thunus. You may recall he was on our show a few weeks ago to play a banking game that he developed to teach high school students about credit risk, liquidity risk, and other risks. Disclosing, measuring, and maintaining capital adequacy and leverage ratios are some of the tools used to mitigate these risks.

In addition to learning the significance and the back story of these ratios, we also go over what capital is in the first place, why these things are not left up to the banks themselves but rather have to be prescribed by someone in Basel (the Basel Committee on Banking Supervision of the Bank for International Settlements, to be exact). We also learn, quite intriguingly, how bankers expect unexpected losses (in addition to expecting the expected losses). Following the famous logic of the former U.S. secretary of defense, Donald Rumsfeld – that there are known knowns, the known unknowns, but also the unknown unknowns – there must be, somewhere, the unexpected unexpected losses. But don’t expect us to talk about these on this podcast!

We are also relieved to hear that, following the sound and sober guidance of Vincent and his colleagues, the EIB enjoys relatively prudent capital adequacy and leverage ratios. Naturally.

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