The Cooke ratio measures a bank’s capital against its risky assets to determine its protection against risk. It was replaced in 2006 by the McDonagh ratio, which allows banks to adjust the rating of individual assets based on the borrower’s risk.
The Cooke ratio is a way of calculating how much capital a bank has relative 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 it was replaced in 2006 with what was considered a fairer calculation method.
The point of the Cooke ratio is to account for the risks inherent in the way that much of the money in a banking system exists only as numbers on paper and not actual cash. It is designed to take into account the fact that the assets held by a bank come in two forms. The first is your capital, which covers the cash you own plus physical assets like buildings. The second is your risky assets, which consist of money you have lent to borrowers and are not guaranteed to get back, as borrowers may default. In theory, the higher the ratio of capital to risky assets, the less likely a bank will be threatened by lower-than-expected borrower repayment levels.
The Cooke relationship was named after WP Cooke, chairman of the Basel Committee on Banking Supervision from 1988 to 1991. This is an international body that sets global 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 that the number of assets at risk is not simply a total of the assets. Instead, each asset is placed into one of five categories, and the total assets in that category are multiplied by a specified 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. The riskiest loans fall into the 10%, 20%, 50%, and 100% categories, meaning that some or all of the asset’s value is included in the grand total.
Over the next few years, critics of the Cooke Ratio complained that these categories were too simplistic. In particular, the banks argued that the system assumed that all loans in a particular category had the same level of risk, regardless of the borrower. In response, officials came up with the McDonagh ratio, named after a successor to Cooke as chairman of the Basel Committee. The McDonagh index maintains the same five categories, but allows banks to adjust the rating of individual assets based on the bank’s assessment of the specific borrower. The McDonagh ratio took over as the official method for the purposes of the Basel Accord since early 2007.
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