What is Capital Adequacy Ratio – CAR?

The capital adequacy ratio (CAR) is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures. The capital adequacy ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured: tier-1 capital, which can absorb losses without a bank being required to cease trading, and tier-2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Calculating CAR

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.

CAR=Tier 1 Capital+Tier 2 CapitalRisk Weighted AssetsCAR = \dfrac{Tier~1~Capital + Tier~2~Capital}{Risk~Weighted~Assets}CAR=Risk Weighted AssetsTier 1 Capital+Tier 2 Capital

Tier-1 Capital

Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-1 capital is used to absorb losses and does not require a bank to cease operations. Tier-1 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-2 Capital

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 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-1 capital.

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. When measuring credit exposures, adjustments are made to the value of assets listed on a lender’s balance sheet.

All of the loans the bank has issued are weighted based on their degree of credit risk. For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%.

Risk-Weighted Assets

Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured with collateral.

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Capital Adequacy Ratio

Why Capital Adequacy Ratio Matters

The reason minimum capital adequacy ratios (CARs) 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. The capital adequacy ratios ensure the efficiency and stability of a nation’s financial system by lowering the risk of banks becoming insolvent. Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.

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 assets.

Off-balance sheet agreements, such as foreign exchange contracts and guarantees, also have credit risks. Such exposures are converted to their credit equivalent figures and then weighted in a similar fashion to that on-balance sheet credit exposures. The off-balance sheet and on-balance sheet credit exposures are then lumped together to obtain the total risk-weighted credit exposures.

Key Takeaways

  • CAR is critical to ensure that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent.
  • CAR is used by regulators to determine capital adequacy for banks and to run stress tests.
  • Two types of capital are measured with 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 a loss in the event of a liquidation. Tier-2 capital provides less protection to its depositors.

Example of Using CAR

Currently, the minimum ratio of capital to risk-weighted assets is 8%under Basel II and 10.5% 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.

For example, suppose bank ABC has $10 million in tier-1 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% ($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.

CAR vs. the Solvency Ratio

Both the capital adequacy ratio and the solvency ratio provide ways to evaluate a company's debt versus its revenues situation. However, the capital adequacy ratio is usually applied specifically to evaluating banks, while the solvency ratio metric can be used for evaluating any type of company.

The solvency ratio is a debt evaluation metric that can be applied to any type of company to assess how well it can cover both its short-term and long-term outstanding financial obligations. Solvency ratios below 20% indicate an increased likelihood of default.

Analysts often favor the solvency ratio for providing a comprehensive evaluation of a company's financial situation, because it measures actual cash flow rather than net income, not all of which may be readily available to a company to meet obligations. The solvency ratio is best employed in comparison with similar firms within the same industry, as certain industries tend to be significantly more debt-heavy than others.

CAR vs. Tier-1 Leverage Ratio

A related capital adequacy ratio sometimes considered is the tier-1 leverage ratio. The tier-1 leverage ratio is the relationship between a bank's core capital and its total assets. It is calculated by dividing Tier-1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures. The higher the tier-1 leverage ratio is, the more likely a bank can withstand negative shocks to its balance sheet.

Limitations of Using CAR

One limitation of the CAR is that it fails to account for expected losses during a bank run or financial crisis that can distort a bank's capital and cost of capital.

Many analysts and bank executives consider the economic capital measure to be a more accurate and reliable assessment of a bank's financial soundness and risk exposure than the capital adequacy ratio.

The calculation of economic capital, which estimates the amount of capital a bank needs to have on hand to ensure its ability to handle its current outstanding risk, is based on the bank's financial health, credit rating, expected losses and confidence level of solvency. By including such economic realities as expected losses, this measurement is thought to represent a more realistic appraisal of a bank's actual financial health and risk level.