everything about capital adequacy ratio

What is the capital adequacy ratio, and why is it important?

The Capital Adequacy ratio (CAR) is understood as how effectively a bank can fulfill its commitments. Authorities use the capital-to-risk weighted assets ratio (CRAR), the percentage that compares capital to risk-weighted assets, to determine the probability that a bank may collapse. It strives to safeguard depositors and enhance the global financial systems' reliability and efficiency.
Centralized banks and banking authorities choose to stop commercial banks from using excessive capital and going bankrupt.

What is the capital adequacy ratio formula?

The capital adequacy ratio can be calculated by dividing a bank's capital by its risk-weighted assets. The capital adequacy ratio formula using which you can calculate the CAR is:  CAR= Risk-Weighted Assets/ Tier 1 Capital + Tier 2 Capital

Is it better to have a high or low capital adequacy ratio?

A high capital adequacy ratio is advantageous because it shows the bank has adequate capital to handle unforeseen financial losses better. When the capital adequacy ratio is lower, a bank is more likely to collapse, which means the financial regulators may need to step in and inject capital.

What is Tier 1 and Tier 2 capital in banks?

Tier 1 capital and tier 2 capital, the two primary forms of capital resources that collectively comprise a bank's capital, are fundamentally distinct in various aspects.

Tier 1: The reported reserves and equity capital included on the bank's financial statements make up the bank's core or tier 1 capital. This money is the foundation for a financial institution's strength and is what a bank needs to operate regularly. Equity of shareholders and retained income from Tier 1 capital, reported on their financial statements, is a crucial metric to evaluate a bank's financial stability. When a bank has to cover losses without stopping operations, these funds come into play. The bank's primary source of funding is Tier 1 capital. Typically, it contains almost all of the bank's total assets. These funds are created mainly to assist banks when losses are taken on without the need to cease normal business operations.

Tier 2: A bank's additional capital is known as Tier 2 capital. These funds consist of undisclosed reserves, subordinated term loans, hybrid financial instruments, etc. Tier 2 capital includes hidden funds not appearing on a bank's financial accounts, revaluation reserves, hybrid capital instruments, Subordinated term debt or junior debt securities, and general loan-loss, or uncollected, reserves. Revalued assets are an accounting technique that establishes a holding's current worth higher than the value recorded initially for it, such as with real estate. Like convertible bonds, securities with equity and debt characteristics are hybrid capital instruments. Because it is less dependable than tier 1 capital, so tier 2 capital is considered additional. Due to the combination of difficult-to-liquidate assets, it is more challenging to quantify precisely. Banks frequently segregate these assets into higher and lower-level pools by the characteristics of every specific asset.

What are the factors affecting the capital adequacy ratio?

An essential aspect of determining a bank's CAR is the degree of risk attributed to its assets. Banks must maintain additional liquidity to cover possible losses if they have more risky assets, such as loans to people with bad credit records. A further significant factor determining a bank's CAR is the amount of capital it has ready. Banks with more outstanding capital are less risky since they can better manage losses. Its CAR is also impacted by the regulatory requirements in the bank's jurisdiction. Banks must meet minimal CAR standards. Banks must adhere to these rules to avoid trouble and get no fines. Changes in economic conditions, such as a recession or inflation, fluctuations in interest rates, and changes in the level of competition in the banking sector can all impact a bank's CAR.

How do banks maintain capital adequacy?

As per RBI guidelines, Private sector Banks must maintain a CAR of 9%, and Public sector banks must maintain a CAR of 12%. By maintaining a specific amount of capital on hand to cover any losses from their lending activity, banks maintain their CAR, or Capital Adequacy Ratio. This capital is determined as a portion of the bank's risk-weighted assets, divided according to the degree of risk each asset entails.

Final Words

Hopefully, you have better understood banks' liquidity and capital adequacy. It discusses a bank's capability to pay commitments and handle operational and credit risks. A bank with a high CAR has enough equity to cover any losses. Going through the details.

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Win Harrison 07 Jun, 2023

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