What is the Capital Adequacy ratio? How does it keep banks solvent?

by Shatakshi Gupta

To maintain global banking health, the Basel committee, with its seat at the Bank of International Settlements, regularly frames some benchmark standards for banks. In this series, Basel-III norms were issued on 3 December 2010. These agreements deal with risk management aspects in the banking sector. These norms have come into effect from March 31, 2015, in several phases. Basel-III is a comprehensive set of reform measures formulated by the Basel Committee on Banking Supervision to strengthen regulation, supervision and risk management in the banking sector. In these norms, a higher Capital Adequacy Ratio was suggested for banks to stay solvent. In this article, we will understand the CAR and its significance in the banking sector.

 What is CAR?

The capital adequacy ratio (CAR) or the capital-to-risk (weighted) asset ratio (CRAR), is the ratio of a bank’s capital to its risky assets. In India, RBI tracks the bank’s CAR to ensure that it can absorb losses and comply with statutory capital requirements.

CRAR is expressed as a percentage of the bank’s risk-weighted credit exposure. Enforcing regulated levels of this ratio is intended to protect depositors and promote the stability and efficiency of financial systems around the world.

Two types of capital are measured to get CRAR. Tier-I capital, which can absorb losses without a bank closing the business, and Tier-II capital, which can absorb losses in the event of a winding-up.

 How CRAR is calculated?

 The capital adequacy ratio (CAR) is a measure of the amount of a bank’s core capital, expressed as a percentage of its risk-weighted assets.

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Tier 1 CAR = (Eligible Tier 1 capital or core capital) / (Market Risk RWA + Credit Risk RWA + Operational Risk RWA)

Total CAR = (Tier-I + Tier-II capital) / (Credit Risk RWA + Market Risk RWA + Operational Risk RWA)

 The percentage limit varies from bank to bank. Basel-III norms recommend keeping it above 8%. However, RBI mandates private banks and public sector banks to keep it above 9% and 12% respectively.

What is its significance?

Capital Adequacy Ratio is the ratio that determines the ability of a bank to meet its time liabilities and other risks such as credit risk, operational risk etc. In the simplest formulation, the bank’s capital is “cushioned” for potential losses, and protects the bank’s depositors and other lenders.  Banking regulators in most countries define and monitor CARs to protect depositors, thereby building trust in the banking system. 

Different types of assets have different risk profiles, CAR primarily adjusts for low-risk assets, allowing banks to “discount” low-risk assets. The specifics of CAR calculations vary from country to country, but the general approach is the same for countries that implement the Basel Agreement. In the most basic application, government debt is allowed a 0% “risk weight”, that is, they are deducted from total assets for calculating CAR.

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