Capital Adequacy Ratio or CAR is a measure of a bank’s ability to absorb losses. We calculate CAR by comparing the ratio of capital to risk. It is part of today’s Capital Adequacy Requirements. Capital Adequacy Ratio is like a bank’s airbag. In other words, it is similar to those that exist in cars to protect us in accidents.
A bank’s capital is the difference between its assets and liabilities. However, there are many ways to interpret what bank capital is.
Regulatory authorities closely monitor the Capital Adequacy Ratio of banks. They monitor them because they want to ensure that banks can absorb losses and meet capital requirements.
Placing a cap on the Capital Adequacy Ratio prevents banks from taking on excess leverage. Excess leverage could subsequently increase the risk of insolvency.
Therefore, banks with high capital adequacy ratios are less likely to become insolvent as a result of sudden losses. Banks with a high CAR are less likely to collapse because they are better at absorbing financial shocks.
Different Types of Capital
The Basel III accord is the latest international framework on how banks should calculate their capital. It has largely been implemented (with further revisions now underway).
The Basel Committee on Banking Supervision devised Basel III in 2012. They created Basel III to “improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source.” In other words, the Committee wanted to make sure that banks could survive major financial crises.
The framework divides the capital of banks into two tiers:
Tier I
This comprises ordinary share capital, audited revenue reserves, future tax benefits, and intangible assets.
Important: Under Basel III, intangible assets (e.g. goodwill) are typically deducted from Tier 1 capital rather than included in it. Similarly, “future tax benefits” (deferred tax assets) may not automatically count fully toward Tier 1; treatment depends on specific rules and thresholds.
Tier II
Tier II comprises unaudited retained earnings, general provisions for bad debts, revaluation reserves, perpetual subordinated debt. It also includes perpetual cumulative preference shares and subordinated debt.
Capital Adequacy Ratio formula
The CAR formula is:
Example of calculating CAR
Here is an example of the process a bank goes through in calculating its capital adequacy ratio:
Step 1: Identify and Determine Total Tier 1 Capital
Example:
- Common equity: USD 80 million
- Retained earnings: USD 20 million
- Certain eligible reserves: USD 5 million
Sum = 80 + 20 + 5 = USD 105 million (Tier 1)
Step 2: Identify and Determine Total Tier 2 Capital
Example:
- Subordinated debt (eligible portion): USD 15 million
- General loan-loss reserves (within regulatory limits): USD 5 million
Sum = 15 + 5 = USD 20 million (Tier 2)
Step 3: Calculate Total Regulatory Capital
From the examples above:
- Tier 1 = USD 105 million
- Tier 2 = USD 20 million
Total Regulatory Capital = 105 + 20 = USD 125 million
Step 4: Calculate Risk-Weighted Assets (RWAs)
- A bank’s assets are categorized and assigned risk weights (e.g., 0%, 20%, 50%, 100%).
- Multiply the value of each asset by its assigned risk weight.
Example:
| Asset Category | Amount (USD million) | Risk Weight | RWA (USD million) |
|---|---|---|---|
| Cash & Reserves | 100 | 0% | 100 × 0% = 0 |
| Government Bonds | 200 | 0% | 200 × 0% = 0 |
| Mortgages (Residential) | 300 | 50% | 300 × 50% = 150 |
| Corporate Loans | 250 | 100% | 250 × 100% = 250 |
| Consumer Loans | 100 | 100% | 100 × 100% = 100 |
| Total | 950 | – | 500 |
So, Risk-Weighted Assets (RWAs) = USD 500 million.
(Note that in reality, each loan category can have additional risk weighting details, but this is a simplified example.)
Step 5: Calculate the Capital Adequacy Ratio
Using the formula:
From the examples above:
- Total Regulatory Capital = USD 125 million
- RWAs = USD 500 million
Step 6: Compare to Regulatory Requirements
Regulators often set minimum required ratios (e.g., around 10.5% under Basel III including buffers, though it can vary by jurisdiction and the type of bank).
In this example, the bank’s CAR of 25% is comfortably above 10.5%, indicating strong capital adequacy.
Second, More Compact Example
- Tier 1 Capital = USD 80 million (common equity + reserves)
- Tier 2 Capital = USD 10 million (subordinated debt, etc.)
- Total Regulatory Capital = 80 + 10 = USD 90 million
- Risk-Weighted Assets = USD 900 million
- CAR = (90 / 900) × 100% = 10%
If the regulatory minimum is 10%, this bank is just at the requirement. Any lower, and the bank would have to raise more capital or reduce risk-weighted assets.
Key points
- The higher the CAR, the more resilient the bank is to unforeseen losses.
- Calculating RWA often involves detailed classification of each type of asset and off-balance sheet exposures.
- Tier 1 is core, high-quality capital; Tier 2 is supplementary. Their exact compositions are carefully defined by regulations (e.g., Basel III).