1. Tier 1 Leverage Capital Ratio (Tier 1 Capital/Average Assets)
2. Tier 1 Risk-Based Capital Ratio (Tier 1 Capital/Risk Weighted Assets)
3. Total Risk-Based Capital Ratio (Total Capital/Risk Weighted Assets)

To aid you with this module, we provide definitions of Tier 1, Tier 2, and Total Capital.

If you're not familiar with risk-based capital, put simply, the Risk-Based Capital ratios attempt to measure capital relative to the bank's risk profile. How do the Risk-Based Capital ratios adjust for different risk profiles? They do this by adjusting individual asset values relative to their risk. Part 325 assigns each item on the balance sheet a predetermined risk weighting from 0% - 100% according to the likely level of risk. Let's look at a very simple example.

From the example above, you can see that risk weighting has a dramatic impact on "total assets". In this example, total assets equaling $10,075 equate to total risk-weighted assets of just $5,910. The Tier 1 Leverage Capital ratio does not take into account the fact that many of these items have little or no risk, but the Risk-Based Capital ratios do. Some things to note:

1. Cash is a risk-less asset and is accordingly allotted a 0% risk weighting since you really don't need a capital allocation for a risk-less asset.
2. Fannie Mae securities are lower risk government sponsored securities and are therefore risk weighted at 20%.
3. Mortgage loans that are current, properly underwritten, and fully secured by first liens on one-to-four family residential properties are risk weighted at 50%.
4. Commercial loans are riskier assets and therefore, have a 100% risk weighting.

We could get very detailed, but what's important from a director's perspective and from an analysis perspective, is that the Risk-Based Capital ratios adjust for portfolio risk. Is this the end of your capital analysis? No, there is one obvious flaw to simply using the risk based capital figures to establish a satisfactory level of capital. For example, even though all commercial loans are risk weighted the same, some commercial loans will have substantially greater risk. Because of this type of risk variance among similar types of assets, ratio analysis is just a starting point when assessing capital. The Report of Examination will help us to develop a more accurate assessment of this bank's risk profile. But before we go to the Report, let's look at these three ratios on the UBPR and assess level and trend.

Note that the capital ratios and other ratios relevant to a capital discussion are highlighted in blue. On the following UBPR summary page for First State Bank, identify the following:

1. The level of the T1 Leverage Capital ratio
2. How does this compare to peer?
3. What is the trend?

Additionally, look to the growth rate section.

1. Can you explain why the Tier 1 Leverage Capital ratio fell so dramatically in 2004?
2. What asset category dominated the growth in total assets in 2004?
3. Does loan growth typically increase or decrease a bank's risk profile?

• Answer

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