What Is the Capital Adequacy Ratio?(Adam Hayes)

What Is the Capital Adequacy Ratio?

By ADAM HAYES

Updated June 24, 2024

Reviewed by DAVID KINDNESS

Reviewed by David Kindness
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Capital Adequacy Ratio?

Definition
The capital adequacy ratio or CAR measures a bank’s available capital expressed as a percentage of its risk-weighted credit exposures.

What Is the Capital Adequacy Ratio?

The capital adequacy ratio (CAR) is an indicator of how well a bank can meet its obligations. Also known as the capital-to-risk weighted assets ratio (CRAR), the ratio compares capital to risk-weighted assets and is watched by regulators to determine a bank's risk of failure. It's used to protect depositors and promote the stability and efficiency of financial systems around the world.

Two types of capital are measured:

Tier-1 capital, core funds on hand to manage losses so that a bank can continue operating and,

Tier-2 capital, a secondary supply of funds available from the sale of assets once a bank closes down.1

Key Takeaways

CAR is critical to ensure that banks have a large enough financial cushion to absorb a reasonable amount of losses before they become insolvent.
CAR is used by regulators to determine capital adequacy for banks and to run stress tests.
Tier 1 and tier 2 capital are both used to measure CAR.
The downside of using CAR is that it doesn't account for the risk of a potential run on the bank, or what would happen in a financial crisis.

Investopedia / Michela Buttignol

Understanding 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.23 High capital adequacy ratios are those that are higher than the minimum requirements under Basel II and Basel III.

A minimum capital adequacy ratio is critical in ensuring that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors’ funds.

The capital used to calculate the capital adequacy ratio is divided into two tiers. The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's capital adequacy ratio.4 Risk-weighted assets are calculated by looking at a bank's loans, evaluating the risk and then assigning a weight. When measuring credit exposures, adjustments are made to the value of assets listed on a lender’s balance sheet.

All of the loans the bank has issued are weighted based on their degree of credit risk. For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%.

Tier-1 Capital

Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-1 capital is the capital that is permanently and easily available to absorb and cushion losses suffered by a bank without it being required to stop operating.

Tier-2 Capital

Tier-2 capital comprises unaudited retained earnings, unaudited reserves, and general loss reserves. Tier-2 capital is the capital that absorbs and cushions losses in the case where a bank is winding up. As such, it provides a lesser degree of protection to depositors and creditors. It is used once a bank loses all its Tier-1 capital.

Risk-Weighted Assets

Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured by a house.

Off-balance sheet agreements, such as foreign exchange contracts and guarantees, also have credit risks. Such exposures are converted to their credit equivalent figures and then weighted in a similar fashion to that of on-balance sheet credit exposures. The off-balance sheet and on-balance sheet credit exposures are then added together to obtain the total risk-weighted credit exposures.

The CAR FormulaCAR=Tier 1 Capital+Tier 2 Capital / Risk Weighted Assets
Example

Suppose Acme Bank has $20 million in tier-1 capital and $5 million in tier-2 capital. It has loans that have been weighted and calculated at $65 million. The capital adequacy ratio of Acme Bank is therefore 38% (($20 million + $5 million) / $65 million).

A CAR of 38% is a high capital adequacy ratio. That means that Acme Bank should be able to weather a financial downturn and losses associated with its loans. It is less likely than banks with less than minimum CARs to become insolvent.

Why the Capital Adequacy Ratio Matters

Minimum capital adequacy ratios are critical. They can reveal whether individual banks have enough financial cushion to absorb a reasonable amount of loss so that they don't become insolvent and consequently lose depositors’ funds.

Broadly, the capital adequacy ratios can help ensure the efficiency and stability of a nation’s financial system by lowering the risk of banks collapsing. Generally speaking, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial commitments.

During the winding up process, funds belonging to depositors are given a higher priority than the bank’s capital. So depositors are only at risk of losing their savings if a bank registers a loss that exceeds the amount of capital it possesses. Thus, the higher the bank’s capital adequacy ratio, the higher the degree of protection for depositors' assets.

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