Capital Adequacy Ratio (CAR) – calculating CAR
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 Cash 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.
According to the Financial Times’ dictionary of terms, capital adequacy ratio is:
“Measure of the financial strength of a bank, expressed as a ratio of its capital to its assets.”
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.
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 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. It also includes perpetual cumulative preference shares and subordinated debt.
Capital Adequacy Ratio formula
The CAR formula is: (Tier 1 Capital + Tier 2 Capital) ÷ (Risk Weighted Assets)
Here are some examples of the process a bank goes through in calculating its capital adequacy ratio