Capital Adequacy Ratio Definition, Formula and Example

The capital adequacy ratio (CAR) is a ratio between a bank’s accumulated capital and risk-weighted assets. The CAR is decided by central banks and regulators to prevent private banks from becoming insolvent. The tier-1 leverage ratio compares a bank’s core capital with 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.

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What is the Capital Adequacy Ratio (CAR)?

The capital adequacy ratio is calculated by dividing a bank’s capital by its risk-weighted assets. Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% (which includes a 2.5% conservation buffer) under Basel III. High capital adequacy ratios are those that are higher than the minimum requirements under Basel II and Basel III. Tier-one capital is used to absorb losses and does not require a bank to cease operations. Capital adequacy ratio or CAR is the ratio of Tier 1 Capital and Tier II capital to the risk weighted assets, of a banking or NBFC company.

CAR is shown as a percentage, representing how much of the bank’s own money is available to cover risky loans. This helps the bank absorb any potential losses before getting into financial trouble. Regulators check CAR to see if a bank can handle financial shocks and to help keep the banking system stable.

In addition to being an indicator used by regulators to assess bank solvency, the capital adequacy ratio is also useful for investors eager to diversify into the banking sector. Before you take a long position in any banking stock, ensure that the company has adequate capital to cover its losses. Risk-weighted assets are calculated by looking at a bank’s loans, evaluating the risk, and then assigning a weight. Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting.

1. The purpose of the agreements is to ensure that banks (and other financial institutions) always have enough capital to deal with unexpected losses.
2. Subordinate debt is debt that has secondary claim to other debt in case the banking company goes bankrupt.
3. Different risk weighting can also be applied to the same asset class.
4. A bank that has a good CAR has enough capital to absorb potential losses.
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CAR uses fixed risk weightings for asset classes, which may not accurately reflect their true risk over time. This static approach can misrepresent a bank’s risk exposure, especially during economic volatility. The Reserve Bank of India (RBI) mandates specific CAR requirements to ensure banks are adequately capitalised. Indian banks must adhere to these norms to operate effectively both domestically and internationally. Assets that do not show any chances of payment by the borrower to the concerned bank are non-performing.

Decoding what the capital adequacy ratio formula means

As it is the core capital held in reserves, Tier 1 capital is capable of absorbing losses without impacting business operations. On the other hand, Tier 2 capital includes revalued reserves, undisclosed reserves, and hybrid securities. Since this type of capital has lower quality, is less liquid, and is more difficult to measure, it is known as supplementary capital. To calculate capital adequacy, you will need to find a bank’s tier 1 and tier 2 capital figures, along with the total value of their risk-weighted assets. Once you have this information, simply divide the sum of tier 1 and tier 2 capital by the total risk-weighted assets. The resulting ratio indicates the bank’s capital buffer relative to its risk exposures.

To ensure that the risk of insolvency is minimised, banks need to adhere to the Capital Adequacy Ratio (CAR). The tier-1 capital of a banking institution, also known as core capital, can absorb losses without stopping financial activities. They are permanently available for transactions and are used to dampen losses in case of insolvent conditions. Banks regard customers’ deposits more in times of dissolution or insolvent conditions. The capital adequacy ratio signals the incidence of such conditions and warns banking institutions against accepting assets with too many risks.

All other types of assets (loans to customers) have a 100% risk what is car in banking weighting. Asset classes that are safe, such as government debt, have a risk weighting close to 0%. Other assets backed by little or no collateral, such as a debenture, have a higher risk weighting. This is because there is a higher likelihood the bank may not be able to collect the loan. Different risk weighting can also be applied to the same asset class. For example, if a bank has lent money to three different companies, the loans can have different risk weighting based on the ability of each company to pay back its loan.

The Minimum Ratio of Capital to Risk-Weighted Assets

Experts consider banks with high CAR values as healthy and able enough to continue their financial operations. Lower values indicate assets are growing riskier, thereby threatening the bank’s capital. With the Basel III agreement, and an added conservation buffer of 2.5%, it is 10.5%.

The State Bank of India struggles to maintain its CAR at 13.3%, although stress test results reveal that it can fall to 11.8%. The COVID-19 pandemic has hit the banking system at its core owing to large public debts and the inability of investors to pay off debts due to insufficient demand. The capital adequacy norms in the Indian public sector banking system thrive to maintain a decent CAR to maintain enough solvency. As of 2022, Bandhan bank has shown promising results with its current CAR at 19.4% despite its Quarter-1 profits doubling to Rs.887 crore. High CAR values indicate banks have enough capital to minimise damage caused by risk-bearing assets. Lower values may indicate that banks are suffering from multiple non-performing assets and gradually emerging into insolvency.

Both the capital adequacy ratio and the solvency ratio provide ways to evaluate a company’s ability to meet financial obligations. Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk. CAR does not account for expected and identifiable losses during financial crises. This oversight can lead to an overestimation of a bank’s financial strength in times of economic stress.

Capital continues to lose value because of the bank’s obligation to safeguard the depositor’s funds. This capital absorbs losses in the event of a company winding up or liquidating. The central bank of a country decides the capital adequacy ratio for banks in that country. You have now seen the capital adequacy ratio formula and computation. So, a high capital adequacy ratio is generally preferred because it means that the company has less risk of becoming insolvent than an entity with inadequate capital.

Regulatory compliance focus

Banks may focus on meeting CAR requirements rather than managing actual risks. This compliance-driven approach can lead to regulatory arbitrage, where banks structure assets to fit regulatory definitions instead of mitigating real risks. For banks listed on the stock market, a strong CAR is a positive signal to investors and analysts, reflecting prudent management and a lower risk profile.