Capital adequacy ratio

Capital adequacy ratio

What is the capital adequacy ratio?

The capital adequacy ratio is actively used in the regulation of the activities of financial institutions. It can be defined in several ways. First, it is the ratio of a bank's capital to its risk-weighted assets and current liabilities (credit exposures). Since loans dominate the bank's assets, the CAR is an indicator of the collateralization of the issued loans with the bank's funds.

The role of the ratio is in establishing certain standards for banks. This way, everyone gets an opportunity to measure the investment attractiveness of banks for investors and depositors or to understand the safety of a credit.

To comply with regulatory requirements, a financial institution must either increase its equity capital or reduce its assets and loan volume. Thus, banks are forced to abandon risky operations, which ultimately increases the level of financial stability.

Capital Adequacy Ratio = (Tier-I + Tier-II (Capital funds)) /Risk weighted assets

Tier-I is core capital, such as equity and disclosed reserves, and Tier-II is supplemental capital.

What do you need to know about the capital adequacy ratio?

To measure the average CAR value, Basel Accord was created in 1988. There we can find several editions with requirements for banks and other financial institutions.

The Basel III norms stipulated a capital to risk-weighted assets of 10.5%. However, some Indian banks have to maintain a CAR of 9-12%. If the bank fails to comply with requirements, the company may be called insolvent, which means that the bank doesn't have enough assets to absorb enough losses.

For example, let's imagine that bank JPM has $100 million in tier-I capital and $50 million in tier-II capital. The loans of the bank have been weighted and calculated as $500 million. The CAR of bank JPM is 30 percent (($100 + $50) / $500). Therefore, JPM has an extremely high capital adequacy ratio (3 times the requirements). As a result, JPM is less likely to become insolvent if unexpected losses occur. 

In a nutshell, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.

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2022-04-19 • Updated

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