Capital Adequacy Ratio for Banks
Updated on March 5, 2023
Capital Adequacy Ratio or CAR is the ratio of a bank’s capital to its risk. It is also known as the Capital to Risk (Weighted) Assets Ratio (CRAR). In other words, it is the ratio of a bank’s capital to its risk-weighted assets and current liabilities. CAR is important from the depositors’ security perspective and also for maintaining the stability of the financial ecosystem.
Capital Adequacy Ratio Explained
Capital adequacy ratio (CAR) is defined as the ratio of a bank’s capital in relation to its assets and liabilities. Banks need to maintain a certain percentage of their debt exposure as their assets, as per regulations. Capital adequacy ratio measures how much capital a bank has, as a percentage of its total debt exposure.
The CAR is decided by central banks or banking regulators to keep commercial banks in check and to prevent them from taking excess leverage.
Calculation of CAR
The CAR or the CRAR is computed by dividing the capital of the bank with aggregated risk-weighted assets for credit risk, operational risk, and market risk.
Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted Assets
Tier-I capital – these constitute the banks’ assets which can help them to tackle any shock without winding up their operations. It is a bank’s core capital including the shareholders’ equity and retained earnings.
Tier-II capital – these constitute the banks’ assets which can help them tackle losses in the event of closure. A bank’s Tier-II capital is made of revaluation reserves, hybrid capital instruments and subordinated term debt.
Tier-III capital: This is a mix of Tier-II capital and the short-term subordinated loans.