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The Cooke ratio is a way of calculating how much capital a bank has in relation to its risky assets. In theory, it indicates how well protected the bank is against risk. The Cooke ratio was once used to calculate a legal minimum figure for banks, but was replaced in 2006 with what was considered a fairer calculation method.
The aim of the Cooke ratio is to take account of the inherent risks of the way much of the money in a banking system exists only as numbers on paper rather than as actual cash. It is designed to account for the fact that the assets owned by a bank come in two forms. The first is its capital, which covers the cash it holds plus physical assets such as buildings. The second is its risky assets, which consists of any money it has lent to borrowers and is not guaranteed to get back as borrowers may default. In theory, the higher the ratio of capital to risky assets, the lower the chance of a bank being threatened by lower-than-expected levels of repayment from borrowers.
The Cooke ratio was named after WP Cooke, the chairman of the Basel Committee of Banking Supervision between 1988 and 1991. This is an international body that sets worldwide standards designed to eliminate excessive risk in banking. In 1988, the committee reached the Basel Accord, which required banks to maintain a Cooke ratio of 8%.
The Cooke ratio calculation works on a risk-weighted basis. This means the risky assets figure is not simply a total of the assets. Instead, each asset is placed into one of five categories and the total of assets in that category are multiplied by a specific percentage. For example, loans to the national government in the bank's own country are considered so safe that the category total is multiplied by 0%, meaning those assets are effectively ignored. Riskier loans fall into the 10%, 20%, 50%, and 100% categories, meaning some or all of the asset's value is included in the overall total.
Over the following years, critics of the Cooke Ratio complained that these categories were too simplistic. In particular, banks argued that the system assumed all loans in a particular category had the same level of risk, regardless of the borrower. In response, officials drew up the McDonagh ratio, named after a successor to Cooke as Basel Committee chairman. The McDonagh ratio keeps the same five categories, but allows banks to tweak the rating on individual assets based on the bank's own assessment of the specific borrower. The McDonagh ratio took over as the official method for Basel Accord purposes from the start of 2007.
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