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.
Is a high CRAR good or bad? ›
In general terms, a bank with a high CRAR/CAR is deemed safe/healthy and likely to fulfill its financial obligations.
What is the capital adequacy indicator? ›
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.
What if capital adequacy ratio is low? ›
A lower ratio means things can get risky. But if a bank's CAR meets or exceeds the threshold set by financial regulators, it is well positioned if it faces losses. Bank for International Settlements. "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems," Page 69.
What does a higher capital ratio mean? ›
Key Takeaways
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 gearing ratio indicate? ›
High gearing ratios indicate a greater proportion of debt financing in the company's capital structure, which can increase the risk of financial distress, bankruptcy, and default. Debt financing comes with interest payments, which increase the overall cost of capital for a company.
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 is a good cash adequacy ratio? ›
A cash flow adequacy ratio of 1 or greater is an indication that the company is generating enough cash to cover its expenses. A cash flow adequacy ratio of less than one means that the company is unable to generate enough cash to cover its short-term expenses.
Bandhan Bank has the highest capital adequacy ratio (CAR) in India.
How to improve capital adequacy ratio? ›
Banks can improve their CAR by increasing the levels of regulatory capital that is the numerator of the capital ratio. They also maintain their CAR by decreasing the risk related to the weighted assets. This has been indicated as the denominator of the capital ratio.
Which ratio is the best indicator of capital? ›
The result of the regression analysis shows that the Short Term Debt to Total Assets Ratio and the Long Term Debt to Total Assets Ratio are the best indicators of capital structure which significantly influence the firm's performance, as measured by the Current Ratio.
What is the Tier 1 capital of a bank? ›
Tier 1 capital is a bank's core capital and includes disclosed reserves—that appear on the bank's financial statements—and equity capital. This money is the funds a bank uses to function on a regular basis and forms the basis of a financial institution's strength. Tier 2 capital is a bank's supplementary capital.
What is capital adequacy ratio for dummies? ›
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. For example, a EUR 1 000 000 mortgage would be relatively low risk, so its risk-weight might be 35%, or EUR 350 000.
What is a good capital ratio for a bank? ›
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 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.
What does a high capital structure ratio mean? ›
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). When assessing the changes in ratio's value over time (over few periods):
