What is capital adequacy ratio (CAR)?
The capital adequacy ratio weighs up a bank’s capital against its risk. The calculation is shown as a percentage of a bank's risk weighted credit exposures.
Key takeaways:
The Capital Adequacy Ratio (CAR) is a measure of a bank's ability to absorb losses and meet its financial obligations.
CAR is calculated by dividing a bank's capital by its risk-weighted assets. The higher the ratio, the better a bank's ability to withstand financial stress.
Banks are required to maintain a minimum CAR as per regulations set by the central bank of their respective countries.
CAR is made up of two components: Tier 1 capital and Tier 2 capital. Tier 1 capital is considered the highest quality capital as it is made up of common equity and retained earnings, while Tier 2 capital consists of subordinated debt and other instruments.
This ratio ensures banks have enough capital to cover potential losses, which protects them from insolvency. The higher the ratio, the more stable and efficient the bank is and the less likely it is to become insolvent.
Where have you heard about capital adequacy ratio?
You may not have heard about the capital adequacy ratio if you are not familiar with banking regulations. However, as a bank depositor, the capital adequacy ratio protects your money by creating a buffer that aims to prevent the bank from collapsing.
What you need to know about capital adequacy ratio
The capital adequacy ratio is calculated by the following:
Tier 1 capital + Tier 2 capital ÷ risk weighted assets
Tier 1 capital is mainly common stock which is able to absorb losses without causing the bank to collapse. Tier 2 capital includes undisclosed reserves, hybrid instruments and revaluation reserves which is less reliable but can to a lesser extent also absorb losses.
The percent threshold for a bank’s capital adequacy ratio is set by the national banking regulator, although many follow the requirements set by the Basel Committee, which is the primary global standard setter for banking regulations. This currently stands at 9% under Basel III.
This threshold maintains banks’ stability by ensuring they do not increase the risk of insolvency by building too much leverage.
What is capital adequacy ratio in simple terms?
Capital Adequacy Ratio (CAR) is a measure of a bank's financial strength and ability to absorb potential losses. It is calculated by comparing a bank's capital to its risk-weighted assets, with higher ratios indicating a bank has a stronger financial position.
What is the capital adequacy ratio formula?
CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-weighted Assets
Where: Tier 1 Capital = Common Equity + Retained Earnings Tier 2 Capital = Subordinated Debt + Other Instruments Risk-weighted Assets = The sum of all assets weighted by their risk factor, where different types of assets are assigned different risk weights according to their perceived risk.
What is good capital adequacy ratio?
A good Capital Adequacy Ratio (CAR) is generally considered to be above the minimum regulatory requirement set by the central bank of a particular country.
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