The Cooke ratio is a way of calculating how much capital a bank has in relation to its risky assets.
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 from risk. The Cooke index was once used to calculate a legal minimum value for banks, but was replaced in 2006 by what was considered a fairer method of calculation.
The purpose of Cooke’s coefficient is to account for the risks inherent in the way in which much of the money in a banking system exists only as numbers on paper rather than real money. It was designed to take into account the fact that a bank’s assets come in two forms. The first is your equity, which covers money that you own more physical assets like buildings. The second is your risky assets, which consist of all the money you have lent to borrowers and are not guaranteed to be received, as borrowers may default. In theory, the higher the capital to risky asset ratio, the less likely a bank is to be threatened by lower-than-expected borrower repayment levels.
The Cooke coefficient is named after WP Cooke, chairman of the Basel Committee on Banking Supervision between 1988 and 1991. This is an international body that sets world standards aimed at eliminating excessive risk in the banking sector. In 1988, the committee reached the Basel Accord, which required banks to maintain an 8% Cooke ratio.
The calculation of Cooke’s coefficient works on a weighted risk basis. This means that the value of risky assets is not simply a total of assets. Instead, each asset is placed in one of five categories and the total 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%, which means that these assets are effectively ignored. The riskiest loans fall into the 10%, 20%, 50%, and 100% categories, meaning that part or all of the asset’s value is included in the grand total.
In subsequent 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 specific category had the same level of risk, regardless of the borrower. In response, officials established the McDonagh index, 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 own assessment of the specific borrower. The McDonagh index became the official method for the purposes of the Basel Accord since the beginning of 2007.