McDonough ratio

Definition

An estimated minimum capital that banks must have in order to mitigate the risks on their assets, such as financial instruments and loans granted, which generally should be greater than 8%. It is used to determine how much capital is required to be maintained by the bank in case of unexpected losses. This ratio is an improvement over the previous version of the Cooke ratio, which did not include weights associated to its loans and financial instruments. This flaw has been eliminated in the new version. The ratio can be calculated as follows:

(Regulatory Capital) / (Credit Risk + Market Risk + Operational Risk) >= 8%

Where: Regulatory Capital = capital and retained earnings of individual company.

Credit risk = risk that the borrower may default. It can be calculated by weighting the total amount of the loan by the quality of the borrower. Market Risk = risk undertaken due to changes in market conditions, applicable to interest-rate products, equities, currencies and commodities. Operational Risk = risk evolving out of internal company management, such as failed processes, people and systems.

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