Capital Adequacy Ratio

Capital Adequacy Ratio (CAR) measures a bank’s capital in relation to its risk-weighted assets. It assesses a bank’s ability to absorb losses and withstand financial shocks. Learn how Capital Adequacy Ratio protects your investments and ensures the banking sector’s stability.

What is the Capital Adequacy Ratio?

Capital Adequacy Ratio (CAR) is a financial metric that determines a bank’s capital with respect to its risk-weighted assets and current liabilities. CAR assesses a bank’s financial stability and ability to absorb losses. It improves the effectiveness and stability of financial systems globally. Capital Adequacy Ratio is also called the capital-to-risk weighted assets ratio (CRAR). 

The central bank of a nation (the Reserve Bank of India in the Indian context) and bank regulators decide over the CAR to prevent commercial banks from taking excess leverage and becoming insolvent.

The RBI has set a minimum CAR of 9% for all banks in India, meaning they must maintain a capital buffer of 9% of their risk-weighted assets. A higher CAR denotes a bank can better withstand losses and continue operating without interruption.

Formula of CAR

CAR is calculated using the below formula – 

In this formula – 

Tier 1 Capital = Tier 1 Capital represents a bank’s core capital and is the most stable and trustworthy form of capital. It includes common equity Tier 1 capital (CET1). Tier 1 capital is the highest quality capital, which can absorb losses without the bank going insolvent. Some examples of tier 1 capital are common stock, retained earnings, qualifying minority interest, non-cumulative perpetual preferred stock, hybrid capital instruments, etc.

Tier 2 Capital = Tier 2 or supplementary capital is usually considered less stable than Tier 1. Tier 2 capital can absorb losses but is subject to more restrictions. Some examples of Tier 2 capital are subordinated debt, undisclosed reserves, revaluation reserves, hybrid security, etc.

Risk-Weighted Assets = Risk-Wighted Assets are the bank's total assets. These assets help assess the risk level a bank is exposed to based on its asset portfolio. Such assets are adjusted for the risk associated with individual assets. For example, loans to individuals and businesses may have lower risk weights than loans to borrowers who are more likely to fall behind or even default on their credit obligations.

Example of CAR 

In this example, we will talk about a fictional bank, say XYZ Bank, operating in the Indian market and needs to calculate its CAR. The bank’s financials are as follows:

Tier 1 Capital (CET1): Rs. 800 million

Tier 2 Capital: Rs. 300 million

Total Risk-Weighted Assets: Rs. 5,000 million

To calculate the CAR, we will use the formula:

=> CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

=> CAR = (Rs. 800 million + Rs. 300 million) / Rs. 5,000 million

=> CAR = Rs. 1,100 million / Rs. 5,000 million

=> CAR = 0.22

To express this as a percentage, multiply the value by 100:

=> CAR = 0.22 x 100 = 22%

So, XYZ Bank’s Capital Adequacy Ratio is 22%.

Result Interpretation

A CAR of 22% suggests that XYZ Bank has a strong capital position. It indicates that the bank holds capital equivalent to 22% of its risk-weighted assets, providing a significant buffer to absorb unexpected losses. This high CAR suggests that XYZ Bank has sufficient capital and is less likely to become insolvent in adverse economic conditions or unexpected losses.

This example demonstrates that XYZ Bank has a healthy CAR, ensuring its financial stability and protecting depositors and investors in the Indian banking market.

Basel III Framework and CAR

The CAR requirements are part of the Basel III framework, an international standard for bank capital adequacy. Countries implement these standards to make their banking systems more resilient and better aligned with global best practices.

Basel-III standards mainly seek to raise the quality and level of capital to ensure financial entities can better absorb losses in the long run.

Regulatory authorities in India, such as the RBI, often set minimum CAR requirements per the Basel III framework to ensure the resilience of banks operating within the country.

Here’s a brief explanation of the requirements:

1. Public Sector Banks: In India, Public sector banks must maintain a minimum CAR of 12%, meaning they must hold capital equivalent to at least 12% of their risk-weighted assets to cover potential losses and absorb financial shocks. 
2. Commercial Banks: Commercial banks must maintain a minimum CAR of 9%. This ensures that these banks have a sufficient capital buffer to withstand economic challenges and protect the interests of depositors and stakeholders.

Key Takeaways

• The capital adequacy ratio is a financial metric that assesses a bank’s financial strength and ability to absorb losses.
• CAR requirements are part of the Basel III framework, which sets international standards for bank capital adequacy.
• CAR safeguards against insolvency and financial instability in the banking sector. 
• It reduces the risk of bank failures and taxpayer-funded bailouts during economic downturns.
• Banks failing to maintain CAR above the minimum requirement may face regulatory actions, such as capital injections, dividend restrictions, or even closure in extreme cases.