Capital adequacy ratio

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Capital Adequacy Ratio (CAR), also known as Capital to Risk (Weighted) Assets Ratio (CRAR),
[1]
is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it
can absorb a reasonable amount of loss and complies with statutory Capital requirements.
It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit
exposures.
This ratio is used to protect depositors and promote the stability and efficiency of financial systems
around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank being
required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up
and so provides a lesser degree of protection to depositors.
Contents
[hide]

1Formula

2Use

3Risk weighting
o

3.1Risk weighting example

4Types of capital

5See also

6References

7External links

Formula[edit]
Capital adequacy ratios (CARs) are a measure of the amount of a bank's core capital expressed as
a percentage of its risk-weighted asset.
Capital adequacy ratio is defined as:

TIER 1 CAPITAL = (paid up capital + statutory reserves + disclosed free reserves) - (equity
investments in subsidiary + intangible assets + current & b/f losses)
TIER 2 CAPITAL = A) Undisclosed Reserves + B) General Loss reserves + C) hybrid debt capital
instruments and subordinated debts

where Risk can either be weighted assets ( ) or the respective national regulator's minimum
total capital requirement. If using risk weighted assets,

10%.[1]
The percent threshold varies from bank to bank (10% in this case, a common requirement for
regulators conforming to the Basel Accords) and is set by the national banking regulator of different
countries.
Two types of capital are measured: tier one capital ( above), which can absorb losses without
a bank being required to cease trading, and tier two capital (
above), which can absorb losses in
the event of a winding-up and so provides a lesser degree of protection to depositors.

Use[edit]
Capital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities
and other risks such as credit risk, operational risk etc. In the most simple formulation, a bank's
capital is the "cushion" for potential losses, and protects the bank's depositors and other
lenders. Banking regulators in most countries define and monitorCAR to protect depositors, thereby
maintaining confidence in the banking system.[1]
CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-toequity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since
assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional
leverage, however, CAR recognizes that assets can have different levels of risk.

Risk weighting[edit]
Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are
less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR calculation vary
from country to country, but general approaches tend to be similar for countries that apply the Basel
Accords. In the most basic application, government debtis allowed a 0% "risk weighting" - that is,
they are subtracted from total assets for purposes of calculating the CAR.

Risk weighting example[edit]

Risk weighted assets - Fund Based : Risk weighted assets mean fund based assets such as cash,
loans, investments and other assets. Degrees of credit risk expressed as percentage weights have
been assigned by the national regulator to each such assets.
Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance sheet
items has to be first calculated by multiplying the face amount of each of the off-balance sheet items
by the Credit Conversion Factor. This will then have to be again multiplied by the relevant
weightage.
Local regulations establish that cash and government bonds have a 0% risk weighting,
and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to
customers) have a 100% risk weighting.
Bank "A" has assets totaling 100 units, consisting of:

Cash: 10 units

Government bonds: 15 units

Mortgage loans: 20 units

Other loans: 50 units

Other assets: 5 units

Bank "A" has debt of 95 units, all of which are deposits. By definition, equity is equal to assets minus
debt, or 5 units.
Bank A's risk-weighted assets are calculated as follows
Cash

Government securities

Mortgage loans

Other loans

Other assets

Total risk

Weighted assets

65

Equity

CAR (Equity/RWA)

7.69%

Even though Bank A would appear to have a debt-to-equity ratio of 95:5, or equity-to-assets of only
5%, its CAR is substantially higher. It is considered less risky because some of its assets are less
risky than others.

Types of capital[edit]
The Basel rules recognize that different types of equity are more important than others. To recognize
this, different adjustments are made:
1. Tier I Capital: Actual contributed equity plus retained earnings.

2. Tier II Capital: Preferred shares plus 50% of subordinated debt.

Different minimum CARs are applied: for example, the minimum Tier I equity allowed by statute
for risk-weighted assets may be 4%, while the minimum CAR when including Tier II capital may be
8%.
There is usually a maximum of Tier II capital that may be "counted" towards CAR, which varies
by jurisdiction.

INVESTOPEDIA

What is the 'Capital Adequacy Ratio - CAR'

The capital adequacy ratio (CAR) is a measure of a bank's capital. It is expressed
as a percentage of a bank's risk weighted credit exposures.
Also known as capital-to-risk weighted assets ratio (CRAR), it is used to protect
depositors and promote the stability and efficiency of financial systems around
the world. Two types of capital are measured: tier one capital, which can absorb
losses without a bank being required to cease trading, and tier two capital, which
can absorb losses in the event of a winding-up and so provides a lesser degree
of protection to depositors.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."

Next Up

1.
2.
3.
4.

TIER 1 LEVERAGE RATIO

TIER 1 CAPITAL
TIER 1 CAPITAL RATIO
TIER 2 CAPITAL

5.

BREAKING DOWN 'Capital Adequacy Ratio - CAR'

The reason why minimum capital adequacy ratios are critical is to make sure that
banks have enough cushion to absorb a reasonable amount of losses before they
become insolvent and consequently lose depositors funds. Capital adequacy
ratios ensure the efficiency and stability of a nations financial system by lowering
the risk of banks becoming insolvent. If a bank is declared insolvent, this shakes
the confidence in the financial system and unsettles the entire financial market
system.
During the process of winding-up, funds belonging to depositors are given a
higher priority than the banks capital, so depositors can only lose their savings if
a bank registers a loss exceeding the amount of capital it possesses. Thus the
higher the banks capital adequacy ratio, the higher the degree of protection of
depositor's monies.

Tier One and Tier Two Capital

Tier one capital is the capital that is permanently and easily available to cushion
losses suffered by a bank without it being required to stop operating. A good
example of a banks tier one capital is its ordinary share capital.
Tier two capital is the one that cushions losses in case the bank is winding up, so
it provides a lesser degree of protection to depositors and creditors. It is used to
absorb losses if a bank loses all its tier one capital.
When measuring credit exposures, adjustments are made to the value of assets
listed on a lenders balance sheet. All the loans the bank has issued are weighted
based on their degree of risk. For example, loans issued to the government are
weighted at 0 percent, while those given to individuals are assigned a weighted
score of 100 percent.

Credit Exposures
Off-balance sheet agreements, such as foreign exchange contracts and
guarantees, have credit risks. Such exposures are converted to their credit
equivalent figures and then weighted in a similar fashion to that of on-balance
sheet credit exposures. The off-balance and on-balance sheet credit exposures
are then lumped together to obtain the total risk weighted credit exposures.
In the United States, the minimum capital adequacy ratio is applied based on the
tier assigned to the bank. The tier one capital of a bank to its total risk weighted
exposure shouldnt go under 4 percent. The total capital, which comprises tier
one capital plus tier two minus specific deductions, so the total risk-weighted
credit exposure should stay above 8 percent.

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