What is Capital Adequacy Ratio?

The capital adequacy ratio (CAR) is the ratio of a bank's available capital to the risks associated with loan disbursement. The capital adequacy ratio, also known as the capital-to-risk weighted asset ratio, is a credit solvency maintenance tool used by banking authorities to assist banks in remaining fiscally fit (CRAR). 

 

Banking regulators frequently request that banks keep and maintain a certain percentage of their debt exposure as to assets. This rate, known as the bank's capital adequacy ratio, is expressed as a percentage. In layman's terms, the capital adequacy ratio measures a bank's capital as a percentage of its total debt exposure.

 

What is the Capital Adequacy Ratio?

 

The capital adequacy ratio is a metric that determines the proportion of a bank's capital to total risk-weighted assets. The credit risk associated with the assets is determined by the bank's entity lending loans. 

 

For example, the risk attached to a loan lent to the government is 0%, but the amount of loan lent to individuals is extremely high in percentage.

 

A percentage is used to represent the ratio.

 

In general, a higher ratio indicates greater safety.

 

A low ratio, on the other hand, indicates that the bank does not have enough capital to cover the risk associated with its assets.

 

As a result, it is capable of resolving any negative crisis that arises during a recession.

 

A very high ratio may indicate that the bank is not making the best use of its capital by lending to its customers.

 

Regulators around the world have implemented Basel 3, which requires them to maintain higher capital in relation to risk in the company's books in order to protect financial systems from another major crisis.

 

Why does Capital Adequacy Ratio matter?

 

Minimum capital adequacy ratios (CARs) are important because they ensure that banks have enough cushion to absorb a reasonable amount of losses before becoming insolvent and losing depositors' funds. 

 

Capital adequacy ratios help to ensure the efficiency and stability of a country's financial system by lowering the risk of banks going bankrupt. A bank with a high capital adequacy ratio is generally regarded as safe and likely to meet its financial obligations.

 

Depositors' funds are given a higher priority than the bank's capital during the winding-up process, so depositors can only lose their savings if the bank incurs a loss that exceeds the amount of capital it possesses. As a result, the higher the bank's capital adequacy ratio, the greater the degree of protection of depositor assets.

 

Credit risks also exist in off-balance-sheet agreements such as foreign exchange contracts and guarantees. These exposures are converted to credit equivalent figures and weighted similarly to on-balance-sheet credit exposures. 

 

The total risk-weighted credit exposures are calculated by combining the off-balance-sheet and on-balance-sheet credit exposures.

 

Also Read | What is Credit Rating?

 

Capital Adequacy Ratio Formula

 

The CAR or CRAR is calculated by dividing the bank's capital by the total risk-weighted assets for credit risk, operational risk, and market risk. The formula of CAR is calculated by adding a bank's tier 1 and tier 2 capitals and dividing the total by the bank's total risk-weighted assets.

 

CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

 

The Bank of International Settlements classifies capital into Tier 1 and Tier 2 based on its function and quality. Tier 1 capital is the primary metric used to assess a bank's financial health. It includes shareholder equity and retained earnings, both of which are reported on financial statements.

 

Tier 1 capital can absorb losses without requiring a bank to stop trading. This includes ordinary share capital, equity capital, audited revenue reserves, and intangible assets. It is also referred to as core capital. This is permanently available capital that can be used to absorb losses incurred by a bank without forcing it to cease operations.

 

Tier 2 capital can absorb losses if the bank goes bankrupt, providing depositors with a lesser level of protection. Unaudited reserves, unaudited retained earnings, and general loss reserves make up this category. This capital absorbs losses after a bank loses all of its tier 1 capital and is used to cushion losses if the bank is winding up.

 

The bottom half of the equation is made up of risk-weighted assets. Risk-weighted assets are the sum of a bank's assets weighted by risk. 

 

Banks typically have different asset classes, such as cash, debentures, and bonds, and each class of asset is associated with a different level of risk. The risk-weighting is determined by the likelihood of an asset's value decreasing.

 

Safe asset classes, such as government debt, have a risk of weighting close to zero percent. Other assets, such as debentures, have a higher risk of weighting because they are backed by little or no collateral. This is due to the increased likelihood that the bank will be unable to collect the loan. 

 

Risk weightings can also be applied to the same asset class. For example, if a bank lends money to three different companies, the loans may have different risk weightings based on each company's ability to repay its loan.

 

Importance of Capital Adequacy Ratio

 

1. The CAR is set by central banks and bank regulators to prevent commercial banks from becoming insolvent due to excessive leverage.

 

2. The CAR is required to ensure that banks have enough room to absorb a reasonable amount of loss before going bankrupt and losing depositors' funds.

 

3. A bank with a high CRAR/CAR is thought to be safe/healthy and capable of meeting its financial obligations.

 

4. Depositors' funds take precedence over the bank's capital when a bank is being wound up, so depositors will lose their savings only if the bank suffers a loss greater than its capital.

 

5. As a result, the higher the CAR, the greater the protection provided by the bank for depositors' funds.

 

6. By lowering the risk of bank insolvency, the CAR contributes to the stability of an economy's financial system.

 

Also Read | Different Types of Loans

 

 

Capital Adequacy Ratio Vs Solvency Ratio

 

Both the capital adequacy ratio and the solvency ratio can be used to assess a company's debt to revenue situation. However, the capital adequacy ratio is typically used to evaluate banks, whereas the solvency ratio metric can be used to evaluate any type of company.

 

The solvency ratio is a debt evaluation metric that can be used to assess how well a company can cover both its short-term and long-term outstanding financial obligations. Solvency ratios less than 20% indicate an increased risk of default.

 

Analysts frequently prefer the solvency ratio for providing a comprehensive evaluation of a company's financial situation because it measures actual cash flow rather than net income, which may not be readily available to a company to meet obligations. 

 

Because some industries are significantly more debt-heavy than others, the solvency ratio is best used in comparison with similar firms within the same industry.

 

Additional understanding of Capital Adequacy Ratio

 

The capital adequacy ratio is the amount of capital set aside by the bank to serve as a cushion for the risk associated with the bank's assets. 

 

A low ratio indicates that the bank lacks sufficient capital to cover the risk associated with its assets. Higher ratios indicate the bank's safety. It is critical in analyzing banks around the world following the subprime mortgage crisis.

 

Many banks have been exposed, and their valuations have plummeted as a result of failing to maintain the optimal amount of capital for the amount of risk they had in their books in terms of credit, market, and operational risks. 

 

Furthermore, with the implementation of the Basel 3 measure, regulators tightened the requirements from the previous Basel 2 in order to avoid another crisis in the future. As a result, many public sector banks in India have fallen short of CET 1 capital, and the government has been gradually increasing these requirements in recent years.

 

 

Example of Capital Adequacy Ratio

 

Calculate Small Bank Inc.'s capital adequacy ratio, i.e. total capital to risk-weighted exposures ratio, using the following data:

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	Exposure	Risk Weight
Government Treasury held as asset	1,500,000	0%
Loans to Corporates	15,000,00	10%
Loans to Small Businesses	8,000,000	20%
Guarantees and other non-balance sheet exposures	6,000,000	10%

 

---

The bank's Tier 1 Capital and Tier 2 Capital are $200,000 and $300,000 respectively.

 

Banks's total capital = 200,000 + 300,000 = $500,000

 

Risk-weighted exposures = $1.5×0% + $15×10% + $8×20% + $6×10% = $3.7 million

 

Capital Adequacy Ratio = $0.5 million ÷ $3.7 million = 14%

 

The bank is safe if the national regulator requires a capital adequacy ratio of 10%. However, if the required ratio is greater than 15%, the bank may face regulatory action.

 

Please keep in mind that guarantees and other non balance sheet exposures are factored into the risk-weighted exposure calculation.

 

Minimum Adequacy Ratio

 

The Basel Capital Accord establishes minimum capital adequacy ratios, which supervisory authorities are encouraged to use. These are as follows: tier one capital to total risk-weighted credit exposures must be no less than 4%;

 

1. Total capital (tier one plus tier two minus certain deductions) to total risk-weighted capital

 

2. Credit exposures must be no less than 8%;

 

There are some additional requirements for tier two capital:

 

1. Tier two capital cannot be more than 100 percent of tier one capital.

 

2. Lower tier two capital may not be more than 50% of tier one capital.

 

3. Lower tier two capital is amortized linearly over the last five years of its life.

 

The Reserve Bank will not register banks in New Zealand that do not meet these standards, and compliance with the minimum standards is always required as a condition of registration.

 

If a registered bank is incorporated in New Zealand, the minimum standards apply to the bank's financial reporting group. It is the capital adequacy if the registered bank is a branch of an overseas bank.

 

The relevant ratios are those of the entire overseas bank (rather than the branch). Overseas Banks that operate as branches are required to be registered in New Zealand. 

 

They meet the capital adequacy ratio requirements imposed by the financial institutions authorities in their home country, and these requirements are no less stringent than those in their home country, The Basel Capital Accord recommends it.

 

When a registered bank falls below the minimum requirements, it must present to the Reserve Bank a plan (which must be publicly disclosed) to restore capital adequacy ratios to at least the minimum level required.

 

Even if a bank has capital adequacy ratios that are higher than the minimum levels recommended by the Basel Capital Accord, this is no guarantee that the bank is "safe." Capital adequacy ratios are primarily concerned with credit risks.

 

Other types of risks are not recognized by capital adequacy ratios, such as inadequate internal control systems, which could result in large losses due to fraud, or losses from trading foreign exchange and other types of financial instruments.

 

The depositors' assets are more valuable than the company's own finances at the time of dissolution. Before the bank can manage the assets of its depositors, CAR ensures that there is a layer of safety in place for the bank to manage its own risk-weighted assets.