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Measuring Bank Capital and Bank Financial Health

     By Don Coker Banking Consultant & Banking Industry Standard Procedures, et al., Expert Witness

PhoneCall Don Coker at (770) 852-2286

Expert Witness: Don Coker
The author draws on his experience as a high-level banking executive, high-level banking regulator, and regulatory-appointed interim manager of several insolvent institutions in this explanation of measuring bank capital and bank financial health.
This article looks at Tier 1 Capital, Tier 2 Capital, the Texas Ratio, and CAMELS Ratings.

Tier 1 and Tier 2 Capital

The definitions of banking capital were largely standardized in the Basel I accord, and were unchanged by the Basel II accord. Banking regulators in most countries have adopted and implemented these definitions for bank capital standards.

Tier 1 Capital is the banking regulators’ primary measure of a bank's financial capital strength, and consists primarily of stockholders' equity and retained earnings. Tier 1 capital may also include certain types of preferred stock (irredeemable and non-cumulative). Tier 1 capital is considered by banking regulators to be the most stable and reliable form of bank capital.

Tier 1 capital includes equity capital and disclosed reserves, where equity capital includes financial instruments that cannot be redeemed by the holder.

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank that are weighted for credit risk according to a formula determined by the banking regulators.

The Bank for International Settlements in Basel, Switzerland, provides guidelines to use in determining asset risk weights. For example, assets such as currency and coins have a zero risk weight, while riskier assets like debentures might have a risk weight of 100%.

Tier 2 Capital is defined in the Basel I Accord to include several different classifications of bank capital:

● Undisclosed Reserves - These reserves occur when a bank has made a profit but the profit has not appeared in the bank’s normal retained profits or in the bank’s general reserves.

● Revaluation Reserves - These are created when a bank revalues an asset and the increase in value is recognized. A simple example may be where a bank owns the land and building of its headquarters and carry them on their books at their acquisition cost many years ago. A current appraisal would show a large increase in the value of the asset that could be added to a revaluation reserve.

● General Provisions - These are created when a company is aware that it is more likely than not that a loss may have occurred but is not sure of the extent of the loss. Under pre-IFRS accounting rules and standards, general provisions were commonly created to acknowledge losses that were anticipated in the future. Since these events did not represent actual incurred losses, banking regulators often allowed the bank to count them as capital.

● Hybrid Instruments - These financial instruments have some characteristics of both debt and stockholders' equity. Provided that these are similar to equity in that they are capable of taking losses on the face value without causing a liquidation of the bank, they may be counted as capital. Preferred stocks are hybrid instruments.

● Subordinated Term Debt - This is debt that ranks lower in liquidation preference than the bank’s depositors.

Texas Ratio

The Texas Ratio compares a bank's non-performing loans (“NPLs”), i.e., its known credit problems, to its level of capital available to deal with its NPLs.

The term Non-Performing Loans is somewhat of a misnomer since its official definition used by the banking regulators includes three categories of problem assets:

1. Properties, also known as “Other Real Estate Owned” or “Real Estate Owned,” that are taken by foreclosure or by a deed-in-lieu of foreclosure.

2. Loans that are ninety days or more past due and still accruing interest.

3. Loans that have been placed on a nonaccrual status, i.e., loans for which interest is no longer accrued and posted to the bank’s income statement.

The Texas Ratio is calculated by dividing the amount of the bank's non-performing loans by the total of its tangible equity capital plus its loan loss reserves.

Texas Ratio = NPLs ÷ (Tangible Equity Capital + Loan Loss Reserves)

Logically, a bank is more likely to fail when its level of problem assets exceeds its capital available to deal with the troubled assets. Accordingly, banks tend to fail when their Texas Ratio reaches 1:1, or 100%. Thus, a Texas Ratio of 100% or greater indicates a higher likelihood of problems in the future.

CAMELS Ratings

CAMELS ratings come from the Uniform Financial Institution Rating System, known by the shorthand abbreviation "UFIRS."

This rating used to be simply a CAMEL Rating until the S was added in the late 1990s. “CAMELS” stands for Capital, Assets, Management, Earnings, Liquidity, and Sensitivity; and represent five key components of a bank’s financial make-up and operations that will be covered during regulatory examinations.

CAMELS ratings are ranked on a scale of 1 to 5 with 1 being the strongest and 5 the weakest.
Banks with ratings of 1 or 2 are considered to have few, if any, financial problems, while banks with ratings of 3, 4, or 5 present moderate to extreme degrees of financial concern and draw more attention from banking regulators.

CAMELS ratings are confidential. A bank's CAMELS rating is never published and is known only to the banking regulators and the bank’s top management, who are obligated to keep the rating confidential.

CAMELS Ratings Summary:

1 is strongest. 5 is weakest.

• (C) Capital adequacy.
• (A) Asset quality.
• (M) Management.
• (E) Earnings.
• (L) Liquidity.
• (S) Sensitivity to interest rate risk and market risk.

Efficiency Ratio

This is a percentage representation of the efficiency of the operations of a bank calculated as follows:

Non-Interest Expense - Amortization Expense of Intangibles
Divided By
Net Interest Income + Non-Interest Income

The answer will be a percentage. It should be 60% or higher. The higher, the better. A higher Efficiency Ration indicates less vulnerability to interest rate fluctuations.


Use these analytical methodologies to establish an estimate of a bank's strength or when comparing banks.

Expert witness and consulting services. 448 cases for plaintiffs & defendants nationwide, 107 testimonies, 12 courthouse settlements, all areas of banking and finance. Listed in the databases of recommended expert witnesses of both DRI and AAJ. Clients have included numerous individuals, 60 banks, and governmental clients such as the IRS, FDIC.

Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, and a two-year term as a high-level governmental banking regulator. BA degree from the University of Alabama. Post-graduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School.

Called on by clients in 28 countries for work involving 57 countries. Widely published, often called on by the media.

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

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