Capital Adequacy Ratio (CAR), part of today’s Cash Adequacy Requirements, is a measure of a bank’s ability to absorb losses by calculating the ratio of capital to risk. CAR can be seen as a bank’s airbag, similar to those installed in cars to protect us in accidents.
There are many ways countries interpret was bank capital is. Basically, it is the difference between the assets and liabilities of a financial institution.
Regulatory authorities keep an eye on the capital adequacy ratio of banks to ensure that they can absorb losses and meet capital requirements.
Placing a cap on the Capital Adequacy Ratio prevents banks from taking on excess amounts of leverage – which would significantly increase the risk of insolvency. Therefore, banks with high capital adequacy ratios are less likely to become insolvent as a result of unexpected losses (as they can absorb them).
According to Reed Business Information Limited, Capital Adequacy Ratio (CAR):
“Determines the capacity of the bank in terms of meeting the time liabilities and other risks such as credit risk, operational risk, etc. CAR below the minimum statutory level indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the banks do not expand their business without having adequate capital.”
The different types of capital
The Basel III accord is the latest international framework on how banks should calculate their capital. It is set to be implemented on March 31, 2018.
Basel III was devised by the Basel Committee on Banking Supervision in 2012 in order to “improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source” and “strengthen banks’ transparency and disclosures.”
The framework divides the capital of banks into two tiers:
Tier I comprises: Ordinary share capital, audited revenue reserves, future tax benefits, and intangible assets.
Tier II comprises: Unaudited retained earnings, general provisions for bad debts, revaluation reserves, perpetual subordinated debt, perpetual cumulative preference shares, and subordinated debt.
The formula for calculating Capital Adequacy Ratio
(Tier 1 capital + Tier 2 capital) / (Risk weighted assets)