What is the 'Capital Adequacy Ratio - CAR'
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)."
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 nation’s 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 bank’s 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 bank’s 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 bank’s 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 lender’s 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.
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 shouldn’t 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.