The capital adequacy ratio (CAR), also known as capital to risk-weighted assets ratio, measures a bank's financial strength by using its capital and assets. Itis used to protect depositors and promote the stability and efficiency of financial systems around the world.
Key Takeaways
- The capital adequacy ratio (CAR) is a measure of how much capital a bank has available, reported as a percentage of a bank's risk-weighted credit exposures.
- The purpose is to establish that banks have enough capital on reserve to handle a certain amount of losses, before being at risk for becoming insolvent.
- Capital is broken down as Tier-1, core capital, such as equity and disclosed reserves, and Tier-2, supplemental capital held as part of a bank's required reserves.
- A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency.
- Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen losses.
How the Capital Adequacy Ratio Is Calculated
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets. The capital used to calculate the capital adequacy ratio is divided into two tiers.
Tier-1 Capital
Tier-1 capital, or core capital, is comprised of equity capital, ordinary share capital, intangible assets, and audited revenue reserves, or what the bank has stored to help it through typical risky transactions, such as trading, investing, and lending. Tier-one capital is used to absorb losses and does not require a bank to cease operations.
Tier-2 Capital
Tier-2 capital comprises unaudited retained earnings, unaudited reserves, and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating. Tier-2 capital is seen as less secure than Tier-1.
The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans, evaluating the risk, and then assigning a weight.
Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.
The Minimum Ratio of Capital to Risk-Weighted Assets
Currently, the minimum ratio of capital to risk-weighted assets is eight percentunder Basel II and 10.5 percentunder Basel III. High capital adequacy ratios are above the minimum requirements under Basel II and Basel III.
Minimum capital adequacy ratiosare critical inensuring thatbanks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors’ funds.
High Capital Adequacy Ratio Example
For example, suppose bank ABC has $10 million in tier-one capital and $5 million in tier-two capital. It has loans that have been weighted and calculated as $50 million. The capital adequacy ratio of bank ABC is 30 percent(($10 million + $5 million) / $50 million). Therefore, this bank has a high capital adequacy ratio and is considered to be safer. As a result, Bank ABC is less likely to become insolvent if unexpected losses occur.
FAQs
A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency. Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen losses.
What does a high capital adequacy ratio indicate? ›
High capital adequacy ratio is good because it indicates that the bank is in a better position to deal with unexpected losses due to availability of adequate capital.
What happens if CRAR is high? ›
In general terms, a bank with a high CRAR/CAR is deemed safe/healthy and likely to fulfill its financial obligations. When a bank is winding-up, depositors' funds are accorded a greater priority than the bank's capital, so depositors will lose their savings only if a bank has a loss higher than the capital it has.
How do you analyze capital adequacy ratio? ›
One can calculate it by dividing the bank's capital by its risk-weighted assets. The ratio represents the form of a percentage. Generally, a higher ratio implies safety. Conversely, a low ratio indicates that the bank does not have enough capital for the risk associated with its assets.
What is the optimal capital adequacy ratio? ›
The Bottom Line
CAR minimums are 8.0% under Basel II and 10.5% (with an added 2.5% conservation buffer) under Basel III. The higher the CAR, the better able a bank should be to meet its financial obligations when under stress.
What does a higher capital ratio mean? ›
A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency. Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen losses.
What does a high capital structure ratio mean? ›
The ratio should take values above 1 (it means that own financing prevails over foreign financing, i.e. debt). Low ratio levels (below 1) are interpreted as substantial debt of the company and low creditworthiness (high ratio levels in turn are interpreted as low debt and high creditworthiness and debt capacity).
What does a high capitalization ratio mean? ›
3. What is a good capitalization ratio? Generally, a cap ratio of 0.5 is seen as low, meaning a company is financing most of its assets through equity. A ratio above 1 means a company is highly leveraged and could be in for some financial trouble.
What does a high capital output ratio indicate? ›
Capital output Ratio indicated the capital used to produce an output over a period of time. High capital output ratio indicated inefficient production technology or capital is cheap as compared to other output.
What does a low Capital Adequacy Ratio indicate? ›
Calculating the Capital Adequacy Ratio (CAR)
These are its tier 1 and tier 2 capital as well as its risk-weighted assets. These are the assets that a bank must hold in its reserves to cut down the chance of insolvency or failure. A lower ratio means that a bank isn't well equipped to deal with losses.
Capital adequacy – the adequate amount (usually defined by regulators) of capital (shareholder money) a bank needs to hold, as a percentage of its risk-weighted assets.
Which bank has the highest capital adequacy ratio? ›
Explanation: Bandhan Bank has the highest capital adequacy ratio (CAR) in India.
What is a good capital ratio? ›
Determining a Good Working Capital Ratio
Generally, a working capital ratio of less than one is taken as indicative of potential future liquidity problems, while a ratio of 1.5 to two is interpreted as indicating a company is on the solid financial ground in terms of liquidity.
What is capital adequacy ratio in simple terms? ›
Capital Adequacy Ratio (CAR) is the measurement ratio that assesses the ability of banks to absorb losses. It standardizes the banks' abilities to pay off its liabilities, tackle credit and operational risks.
What is Bests capital adequacy ratio? ›
Also known as Best's Capital Adequacy Ratio, BCAR, examines an insurer's leverage, underwriting activities, and financial performance and uses this information to test various scenarios to see how each would impact the insurer's balance sheet.
Should capital adequacy ratio be less or more? ›
What are the Requirements? Under Basel III, all banks are required to have a Capital Adequacy Ratio of at least 8%. Since Tier 1 Capital is more important, banks are also required to have a minimum amount of this type of capital. Under Basel III, Tier 1 Capital divided by Risk-Weighted Assets needs to be at least 6%.
What does a low capital adequacy ratio indicate? ›
Calculating the Capital Adequacy Ratio (CAR)
These are its tier 1 and tier 2 capital as well as its risk-weighted assets. These are the assets that a bank must hold in its reserves to cut down the chance of insolvency or failure. A lower ratio means that a bank isn't well equipped to deal with losses.
What does a higher level of capital output ratio indicates? ›
Capital output Ratio indicated the capital used to produce an output over a period of time. High capital output ratio indicated inefficient production technology or capital is cheap as compared to other output.
What does a high working capital ratio indicate? ›
A high working capital ratio means that the company's assets are keeping well ahead of its short-term debts. A low value for the working capital ratio, near one or lower, can indicate that the company might not have enough short-term assets to pay off its short-term debt.
