Financial Risk Management

CHAPTER 2The Basel I Regulatory Framework and the Cooke Ratio

CAPITAL ADEQUACY

With the aim to protect internationally active banks in the G10 countries against bankruptcy, the Basel Committee developed in 1988 a common solvency ratio, known as the Cooke ratio, named after Peter Cooke, the Chairman of the Basel Committee at this time. According to BCBS (1988), through this new solvency ratio, the fundamental objective is to “strengthen the soundness and stability of the international banking system […] with a view to diminishing competitive inequality among international banks”. Stated differently, credit institutions competing for the same loans should comply with the same capital‐backing constraints, and thus set aside roughly the same amount of capital. Although the Cooke ratio focuses on credit risk, the Committee acknowledges that other types of risk, such as interest risk, exchange rate risk, concentration risk and the investment risk on securities, should also be considered in assessing overall capital adequacy.¹

The Cooke ratio is a solvency ratio because it requires international banks to hold capital for credit equal to at least 8% of the Risk‐Weighted Assets (RWA). For example, it means that to lend €100m, a bank should own at least €8m of capital. The Cooke ratio is defined as follows:

where RWA is defined as the bank's asset weighted by its Risk Weight (RW). These ...