The capital adequacy ratio (CAR) measures the amount of capital a bank retains compared to its risk. National regulators must track the CAR of banks to determine how effectively it can sustain a reasonable amount of loss. National regulators must also determine if a bank’s current CAR is compliant with statutory capital regulations. The CAR is important to shareholders because it is an important measure of the financial soundness of a bank.

Two types of capital are measured with the CAR. The first, tier 1 capital, can absorb a reasonable amount of loss without forcing the bank to cease its trading. The second type, tier 2 capital, can sustain loss in the event of liquidation. Tier 2 capital provides less protection to its depositors.

How a Bank Borrows Funds

In relation to the amount of funds borrowed and deposits made, the amount of shareholders' equity within a bank is comparatively small. Because of this, banks are typically highly leveraged, which requires banks to operate on a higher plane of borrowing than would be seen in most other businesses.

In general, a business borrows funds approximately equal to its net worth. A bank, by contrast, has liabilities that are typically in excess of 10 times its equity capital. The greatest part of those liabilities are representative of smaller sums of money depositors have entrusted to the bank.

Because of the nature of risk under which banks operate, capital regulations require banks to maintain a minimum level of equity per loans and other assets. This required minimum is designed for protection, allowing banks to sustain unanticipated losses. The minimum is also designed to offer depositors confidence in the security of their deposits given the asymmetric information.

An individual depositor cannot know if a bank has taken risks beyond what it can absorb. Thus, depositors receive a level of assurance from shareholder equity, along with regulations, audits and credit ratings.

The amount of equity a bank receives from shareholders sets the limit on the value of deposits it can attract. This also limits the extent to which the bank can lend money. If a bank sustains large losses through credit or trading, eroding the bank’s net worth, this causes a decreased fund base through which a bank can offer loans.

The CAR provides shareholders with a better understanding of the risks a bank is taking with the equity they provide. A bank that continually takes more risks than it can reasonably sustain leaves potential shareholders with a sense their equity investments are more at risk. A bank must maintain a professional level of risk management and sound lending practice to attract the capital that acts as its first line of defense against loss, both expected and unforeseen.

(For related reading, see "What Are the Biggest Risks Associated With Banks Today?")

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