Capital Adequacy Ratio (CAR): Definition & Overview Guide

When it comes to financial institutions, there are several regulations to follow to help mitigate risk. Banks allow you to not only keep your money in one place but also invest it to earn more money. But what do you think would happen if your bank ran out of money?

There is always money coming in and money going out at financial institutions. And it’s critical that they have a cushion just in case something happens. What if a bank doesn’t have enough capital adequacy or they become insolvent?

The good news is there are things in place to help ensure that doesn’t happen.

Here’s What We’ll Cover:

What Is Capital Adequacy Ratio?

Calculating Capital Adequacy Ratio

Why Is Capital Adequacy Ratio Important?

Key Takeaways

What Is Capital Adequacy Ratio?

The capital adequacy ratio is a way to measure a bank’s available capital against risk-weighted credit exposures. It can also be known as the capital-to-risk assets ratio (CRAR). And it’s used to help protect depositors in case something unforeseen happens. It also promotes the efficiency and stability of global financial systems.

There are two types of capital that get measured in the capital adequacy ratio: tier-1 capital and tier-2 capital.

Tier-1 capital is meant to absorb potential losses without the bank having to stop trading. At its core, tier-1 capital will consist of things like equity capital and audited revenue reserves. It can also include ordinary share capital and intangible assets to absorb losses.

It’s the capital that is available to help cushion substantial losses without having to pause operations altogether. A common example of tier-1 capital for a bank would be ordinary share capital.

Tier-2 capital can also absorb potential losses. But it consists of unaudited retained earnings, general loss reserves and unaudited reserves. Tier-2 capital almost serves as a fall-back should a bank lose all of its tier-1 capital.

Both of these tiers get added together and then divided by your risk-weighted assets. This helps calculate the capital adequacy ratio. You can calculate risk-weighted assets by taking a look at things like loans, evaluating the overall risk and then assigning a weight.

Calculating Capital Adequacy Ratio

To calculate the capital adequacy ratio, you divide capital by risk-weighted assets. The formula would look like this:

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

Why Is Capital Adequacy Ratio Important?

There are several reasons why the capital adequacy ratio is important. It helps to make sure that banks have more than enough cushion to help absorb any losses. And this gets done before the bank becomes insolvent.

It also helps make sure that the entire financial system is both efficient and stable. Most often, banks that have higher capital adequacy ratios are considered to be safe and able to meet their financial obligations.

During the winding-up process, any finds that belong to depositors have a higher priority compared to the bank’s capital. So if a bank registers a significant loss that exceeds the amount of capital it processes, depositors can lose their savings. The higher the capital adequacy ratio, the more protection depositors’ assets will have.

Key Takeaways

The capital adequacy ratio helps measure a bank’s ability to meet obligations by comparing how much capital it has against its assets. It’s monitored by regulatory authorities and the process is implemented to see if a bank is at risk of failure.

The idea is to monitor and protect the financial system should something happen. This ultimately protects the funds of bank depositors. To calculate the capital adequacy ratio, you can use this formula:

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

Tier-1 capital gets used to help absorb losses without the bank having to completely stop operations or trading. This can include future tax benefits, share capital or audited revenue reserves.

Tier-2 capital is accessible by stopping operations and seeing off your assets. This can include unaudited retained earnings, general provisions or subordinated debt.

If the capital adequacy ratio is high it might indicate a bank has enough capital to handle any unexpected losses if something were to happen. However, if the capital adequacy ratio is low, it might mean the bank is at risk of failure. If this is the case, the bank might get required by regulatory authorities to generate extra capital.

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