What is Capital Adequacy Ratio CAR and Its Formula?

This indicates an increase in the riskiness of its assets against its capital for that financial year. Tier-2 capital, a secondary supply of funds available from the sale of assets once a bank closes down. Investment in the securities involves risks, investor should consult his own advisors/consultant to determine the merits and risks of investment. Investments in the securities market are subject what is car in banking to market risk, read all related documents carefully before investing.

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Since Tier 1 Capital is more important, banks are also required to have a minimum amount of this type of capital. Under Basel III, Tier 1 Capital divided by Risk-Weighted Assets needs to be at least 6%. Examples of such capital include undisclosed reserves, cumulative preference shares, revaluation reserves, subordinated debt, and loss reserves. It includes stable and liquid items like the paid-up capital, statutory reserves, retained earnings and other free reserves disclosed in the balance sheet. Banks are increasingly raising more capital to sustain a decent CAR value to maintain bank capital adequacy. As of 2021, the ICICI Bank plans to raise Rs. 15,000 crores to cushion its growing non-performing assets.

Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-1 capital is the capital that is permanently and easily available to absorb and cushion losses suffered by a bank without it being required to stop operating. For example, suppose bank ABC has $10 million in tier-one capital and $5 million in tier-two capital. The capital adequacy ratio of bank ABC is 30 percent (($10 million + $5 million) / $50 million).

When measuring credit exposures, adjustments are made to the value of assets listed on a lender’s balance sheet. The capital adequacy ratio (CAR), also known as capital to risk-weighted assets ratio, measures a bank’s financial strength by using its capital and assets. It is used to protect depositors and promote the stability and efficiency of financial systems around the world. The purpose of the Capital Adequacy Ratio (CAR) is to ensure that banks have enough capital to absorb potential losses and remain solvent. By requiring banks to maintain a certain level of capital relative to their risk-weighted assets, CAR helps prevent excessive leverage and promotes financial stability. This protects depositors and supports the overall integrity and efficiency of the banking system.

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As of 2022, RBI has stated that banks with deposits of more than Rs. 100 crore must maintain a minimum CAR of 12% from a previously maintained 9%. However, RBI plans to adopt a four-tiered regulatory framework that would check the financial soundness of Indian banks. The only drawback would be that during economic turmoil like inflation and liquidity traps, CAR cannot measure expected losses, which, in turn, can dent the bank’s capital.

Under Basel III norms of BIS, the minimum CAR that banks should maintain is 8%. Under RBI’s current guidelines, public sector banks should have a CAR of at least 12%. The purpose of CAR is to indicate to the ability of a bank or NBFC to absorb losses in the case of materialization of extreme risks. A higher CAR means that a bank or NBFC has higher ability to absorb losses without going insolvent, in the case of materialization of extreme risks. However, the ideal ratio depends on factors like bank size, operations, and economic conditions. It suggests a bank has sufficient capital to absorb potential losses, making it more stable and reliable.

1. It ensures that banks have enough capital to absorb potential losses and avoid insolvency.
2. Before you take a long position in any banking stock, ensure that the company has adequate capital to cover its losses.
3. CAR provides a detailed, risk-sensitive measure, whereas the Tier-1 Leverage Ratio offers a simpler, more direct assessment of leverage.

Risk weighting

To better understand the significance of the CAR for depositors, investors, and other stakeholders, let us discuss the capital adequacy ratio formula. The Reserve Bank of India oversees the implementation of CAR in India with a minimum prerequisite of 9% for scheduled commercial banks and 12% for public-sector commercial banks. Central banks and financial regulators set the ratio in such a way that banks can digest risk-bearing elements. Normally, banks have enough reserves to ease out losses, thus preventing them from losing customer deposits. They are a trio of regulatory agreements formed by the Basel Committee on Bank Supervision.

Tier-1 Capital

A stable banking system is fundamental to sustaining economic growth. Let us understand how the capital adequacy ratio formula works with the help of a hypothetical example. The international regulatory framework Basel III requires banks to maintain a minimum capital adequacy ratio of 10.5%. The capital adequacy ratio is intended to ensure that banks have enough funds available to handle a reasonable amount of losses and prevent insolvency. Analysts often favor the solvency ratio because it measures actual cash flow rather than net income, not all of which may be readily available to a company to meet debt obligations. The solvency ratio is best used to compare debt situations of similar firms within the same industry, as certain industries tend to be significantly more debt-heavy than others.

Solvency ratio:

The U.S.’s Federal Deposit Insurance Company (FDIC) calls for an 8% minimum ratio for total capital to total risk-weighted assets. All things considered, a bank with a high capital adequacy ratio (CAR) is perceived as healthy and in good shape to meet its financial obligations. Tier-2 capital comprises unaudited retained earnings, unaudited reserves, and general loss reserves. Tier-2 capital is the capital that absorbs and cushions losses in the case where a bank is winding up. As such, it provides a lesser degree of protection to depositors and creditors. Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.

It is expressed as a percentage of a bank’s risk-weighted credit exposures. The enforcement of regulated levels of this ratio is intended to protect depositors and promote stability and efficiency of financial systems around the world. The capital adequacy ratio is computed by dividing the total capital of a bank by its risk-weighted assets. This is why the CAR is also called the Capital to Risk (Weighted) Assets Ratio (CRAR). It can help to know the prevailing CAR, how it is calculated and what it can tell you about a bank’s financial strength. Check out these key details of the capital adequacy ratio and more in this article.

For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%. For example, the minimum Tier I equity allowed by statute for risk-weighted assets may be 6%, while the minimum CAR when including Tier II capital may be 8%. Under Basel III, all banks are required to have a Capital Adequacy Ratio of at least 8%.