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 capital adequacy ratio (CAR) is a measure of how much capital a bank has available, reported as a percentage of a bank's risk-weighted credit exposures.
- The purpose is to establish that banks have enough capital on reserve to handle a certain amount of losses, before being at risk for becoming insolvent.
- Capital is broken down as Tier-1, core capital, such as equity and disclosed reserves, and Tier-2, supplemental capital held as part of a bank's required reserves.
- A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency.
- Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen losses.
How the Capital Adequacy Ratio Is Calculated
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets. The capital used to calculate the capital adequacy ratio is divided into two tiers.
Tier-1 capital, or core capital, is comprised of equity capital, ordinary share capital, intangible assets, and audited revenue reserves, or what the bank has stored to help it through typical risky transactions, such as trading, investing, and lending. Tier-one capital is used to absorb losses and does not require a bank to cease operations.
Tier-2 capital comprises unaudited retained earnings, unaudited reserves, and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating. Tier-2 capital is seen as less secure than Tier-1.
The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans, evaluating the risk, and then assigning a weight.
Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.
The Minimum Ratio of Capital to Risk-Weighted Assets
Currently, the minimum ratio of capital to risk-weighted assets is eight percent under Basel II and 10.5 percent under Basel III. High capital adequacy ratios are above the minimum requirements under Basel II and Basel III.
Minimum capital adequacy ratios are critical in ensuring that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors’ funds.
High Capital Adequacy Ratio Example
For example, suppose bank ABC has $10 million in tier-one capital and $5 million in tier-two capital. It has loans that have been weighted and calculated as $50 million. The capital adequacy ratio of bank ABC is 30 percent (($10 million + $5 million) / $50 million). Therefore, this bank has a high capital adequacy ratio and is considered to be safer. As a result, Bank ABC is less likely to become insolvent if unexpected losses occur.