Capital Adequacy Ratio Explained

Capital Adequacy Ratio Explained

What is capital adequacy ratio? How is it calculated for any bank? Read to know all about this important banking parameter.
Can you imagine an economy functioning without a banking system in place? Without credit lines open, there would be no enterprise or let's say it would be difficult to set up any business. Banks not only provide credit lines, but also have people's savings deposited in them. As the recent subprime crisis and economic recession brought the banking system to its knees, a need for greater governmental control on banks was felt. One of the crucial binding regulations on banks, imposed by law, is the capital adequacy ratio. It is one of the several measures introduced by the government to ensure that banks stay solvent and protect public savings.

Every financial venture comes with a degree of risk that needs to be taken into consideration. Even setting up a bank and running it comes with a high amount of risk. Risk management is possible if one can calculate and quantify it. Capital adequacy ratio is one such measure that can help determine how well protected a bank is against risk.

Definition

Capital adequacy ratio (CAR) is the measure which determines if a bank has adequate capital. Its maintenance offers protection against the risk associated with a bank's credit offerings and other financial ventures. It is also known as capital to risk weighted asset ratio. CAR is the ratio of a bank's total capital, against the total amount of financial risk that it is exposed to.

Expressed as a percentage, it is the measure of a bank's ability to sustain itself against losses, arising out of credit risks, financial risks, and operational risks associated with its ventures. It is required by the laws of every country, that a minimum amount of CAR be maintained by every bank. Every country has a different set value for it, which needs to be maintained.

According to international agreements called the Basel accords, many countries have agreed to maintain the CAR percentage at a specified level. In the aftermath of the economic recession, additional restraints were imposed on banks to ensure that they are better protected against extreme economic risks that arise periodically. A high CAR means that a bank is better protected against risk.

A bank's capital that is used in the calculation of CAR constitutes two types - Tier 1 and Tier 2. Tier 1 consists of assets that a bank can sell in event of losses and still stay operational. Tier 2 capital consists of assets that a bank will have to liquidate in case of ceasing of operations. The risks involved in calculation of the CAR are all the loans and investments made by the bank which are subject to market risks of all kinds.

Calculation

There is a set formula for calculation, which can accurately estimate a bank's protection against all kinds of liabilities that may arise from market risk. Here it is:

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

The kind of assets included in Tier 1 and Tier 2 capital may vary from country to country, but they generally include risk-free investments and undisclosed reserves, as well as low-risk investments. The Tier 2 capital consists of undisclosed assets and other cash reserves, which constitute a bank's insurance of sorts, in case of closing down. This ratio is usually expressed in percentage, by multiplying it with 100.

Thus, the maintenance of a minimum capital adequacy ratio is a restraint imposed on banks to ensure that they maintain solvency. The recent economic recession exposed the vulnerabilities of the banking sector quite clearly. It is obvious that more control and regulations are needed to keep the banks and people's savings afloat, in a hazardous economic climate.
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