Bank capital adequacy: how much growth and how many dividends the ratio allows

Capital adequacy is the ratio of a bank's own funds to its risk-weighted assets, and it is this ratio, not profit and not revenue, that determines how many new loans the bank can make and how much of its profit it is entitled to hand to shareholders. For a corporate finance professional the ratio works as a budget constraint: capital is a scarce resource, every ruble of risk on the balance sheet consumes it, and dividends and share buybacks remove it for good. As long as the headroom above the required level is large, the bank has room both to grow and to pay out. When the headroom shrinks, it has to choose between the two.

The numerator: capital is not uniform

A bank's own funds are not read off one line of the balance sheet. They are counted in layers, and the layers differ in their ability to absorb losses without the bank ceasing to operate. Common equity capital consists of ordinary shares, share premium and accumulated retained earnings: this is the "hardest" layer, which absorbs losses first and without any legal procedures. Additional capital consists of perpetual instruments that are converted or written down when specified conditions are triggered; together with common equity it forms core capital. Supplementary capital consists of subordinated liabilities with a fixed maturity; it helps creditors in a liquidation, but it is of little help to a bank that is still operating.

Deducted from each layer are the items that will not turn into cash in a crisis: goodwill and other intangible assets, deferred tax assets, investments in the capital of other financial institutions and, sometimes, loans granted to shareholders. This is why capital under the regulatory methodology and capital in a report prepared under financial reporting standards are different quantities, and they cannot be compared directly. The movement of these layers between reporting dates can be seen in the statement of changes in equity, where share issues, payouts and revaluations are shown separately.

The denominator: risk-weighted assets

The point of weighting is that a ruble of a claim on the state and a ruble of an unsecured consumer loan consume capital differently. Each asset is assigned a risk weight; reliable claims receive a zero or reduced weight, risky ones an increased weight, and for particular types of lending the regulator adds surcharges to the weights in order to cool a segment without changing the key rate. Operational risk and market risk are added to credit risk, and operational risk is calculated from the scale of the business and can hardly be reduced quickly.

This leads to a practical conclusion that is often overlooked: the ratio does not improve only through a capital injection. It also improves through a change in the structure of assets: a shift into segments with a lower risk weight, securitisation, obtaining collateral and guarantees, and developing fee and commission business, which brings in income while barely inflating the denominator. Large banks that have received permission to measure risk using internal ratings estimate the weights with their own models, and with a carefully managed portfolio this releases capital.

Buffers: where the freedom to dispose of profit ends

On top of the minimum ratios there are buffers: the capital conservation buffer, the countercyclical buffer and the buffer for systemic importance. Their distinctive feature is that breaching a buffer does not cost the bank its licence: it restricts the distribution of profit. A bank that has entered the buffer zone is obliged to cut dividends, share buybacks and management bonuses until it has rebuilt the buffer. This is exactly why dividend policy in the banking sector is always secondary to capital: the board of directors may want to pay out, but the distributable base is capped by the regulatory headroom. Planned payouts on the sector's securities are conveniently viewed in the dividend calendar, and their history in the dividends section.

Why this is the central indicator for corporate finance

Capital adequacy ties together three decisions that are discussed separately in a non-bank company: the pace of growth, financial leverage and payouts to shareholders. For a bank, the sustainable rate of asset growth is limited by return on equity less the share of profit that goes to dividends: a bank cannot grow its risk-weighted assets faster than profit replenishes its capital. If you want to grow faster, you either lower the payout ratio, or issue shares, or shift into assets with a lower risk weight.

This is also where the link to valuation comes from. A high return on equity with thin capital headroom is a signal that the return has been achieved partly through leverage and is vulnerable; the same figure with thick headroom means excess capital, which will either be returned to the shareholder or will dilute returns. Comparing the return with the cost of equity and the logic of the ROIC–WACC spread apply here too, with one adjustment: a bank's "target leverage" is set not by the market but by the regulator, so the familiar target capital structure turns into target headroom above the regulatory ratio. It is also useful to keep capital outflow in mind: withdrawals of funds by non-residents and swings in funding hit the ratios sooner than they hit the income statement.

A separate channel of influence is interest rates. When rates rise, the revaluation of the debt securities portfolio reduces capital through the accumulated revaluation loss, while claims on borrowers deteriorate with a lag. The mechanics of how the regulator's decisions are transmitted to a bank's balance sheet are set out in the article on the key rate; benchmark yields are conveniently viewed in the OFZ section.

What to look at in practice

Look for banks' disclosures and regulatory reporting in the reports section, for quotes and valuation multiples of bank securities in the stocks section, and for definitions of related concepts in the glossary. A useful habit is to look not at the level of the ratio itself but at the headroom above the required minimum including the buffers, and at what that headroom has been built from: earned profit, a one-off revaluation, a sale of assets or regulatory relief.