How to Simply Understand Capital Adequacy Ratio and Formula

Capital Adequacy Ratio Formula: Is High CA Ratio Good or Bad?

Let's talk about something crucial for the stability of banks: the capital adequacy ratio. This ratio evaluates a bank's resilience to financial shocks and overall strength. It indicates how well-equipped a bank is to withstand possible losses. It is computed by dividing its capital by its risk-weighted assets. 

The capital adequacy ratio formula is simply capital divided by risk-weighted assets. It functions as a safety net for banks, ensuring they have the cushion to withstand unanticipated downturns. Let's examine this crucial financial indicator in more detail now and see why the banking sector finds it to be so significant.

Key Highlights

  • The CAR is like a bank's superhero strength, showing how much capital it has compared to its risky credit exposures.

  • Banks must ensure they have sufficient capital reserves to handle potential losses without risking insolvency.

  • Capital is divided into two parts: Tier-1, which includes equity and disclosed reserves, and Tier-2, which is supplemental capital held by banks as part of their required reserves.

  • A bank with a strong capital adequacy ratio is deemed solvent, surpassing the minimum requirements.

  • A bank with a high CAR is like a sturdy fortress, ready to weather any financial storm or unexpected setbacks.

What Is the Capital Adequacy Ratio in Simple Terms?

The Capital Adequacy Ratio, which evaluates a bank's capacity to meet obligations and manage operational and credit risks, established guidelines for banks. A bank with a high CAR is well-capitalized to withstand possible losses. 

Thus, it is unlikely to declare itself bankrupt and run away with depositors' money. BIS introduced more stringent CAR requirements in the wake of the 2008 financial crisis to safeguard the interests of depositors.

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Bank's capital adequacy ratios (CAR) reflect their ability to pay their obligations. Regulators use this ratio, commonly called the CRAR or capital-to-risk-adjusted assets (RARA), as a measure of relative financial strength and the likelihood that a bank is about to fail. It safeguards depositors and advances the global financial systems' efficiency and stability.

What Is Tier 1 and Tier 2 Capital?

Two layers of capital are utilized to compute the capital adequacy ratio. A bank's capital adequacy ratio (CAR) is calculated by multiplying the sum of the two capital tiers by risk-weighted assets.

Tier-1 capital, or core cash on hand to manage losses so that a bank may continue operating, is one sort of capital that is measured. 

Equity capital, ordinary share capital, intangible assets, and audited revenue reserves comprise Tier-1 capital, also known as core capital. Tier-1 capital is the readily available capital banks can always rely on to absorb losses and protect themselves without shutting down.

Tier-2 capital is a backup source of money that can be obtained through asset sales if a bank shutters. Tier-2 capital consists of unaudited retained profits, unaudited reserves, and general loss reserves. 

The capital that absorbs and softens losses if a bank is closing is known as Tier-2 capital. As a result, depositors and creditors are given less protection. When a bank exhausts its Tier-1 capital, it is used.

Capital Adequacy Ratio Formula with Example

The Capital Adequacy Ratio (CAR) is calculated using the following formula:

                                                    

                                     CAR = Tier 1 + Tier 2‚Äč / Risk Weighted Assets 

Where:

  • Tier 1 Capital includes common equity and disclosed reserves.

  • Tier 2 Capital includes supplementary capital like subordinated debt and hybrid instruments.

  • Risk-weighted assets are adjusted for credit, market, and operational risk.

For example, if the bank were to have $200 million on risk-weighted assets with $10 million in Tier 1 capital and $5 million in Tier 2 capital.

CAR = 10 + 5 + 200 \times 100%

CAR = 15 + 200 \times 100% 

CAR = 7.5%

As a result, the capital adequacy ratio would be 7.5%.

Another Example

Acme Bank has tier-1 capital of $20 million and tier-2 capital of $5 million. It boasts a hefty $65 million loan, meticulously weighed and calculated. Acme Bank's capital adequacy ratio is a solid 38%, calculated by adding $20 million and $5 million, then dividing by $65 million.

A 38% CAR is a solid fortress of financial strength. Acme Bank is well-prepared to handle economic challenges and loan losses. Banks with low CARs are more prone to insolvency.

How Do You Calculate Capital Adequacy?

Here's a general step-by-step procedure for calculating capital adequacy:

A bank's CAR or capital adequacy ratio that results from dividing capital over risk-weighted assets reflects its ability to meet its responsibility obligations. It is one of the tools regulators consider when measuring the amount of capital compared with risk-weighted assets and, therefore, determines a bank's chances of going belly up.

  1. Determine the bank's Tier-1 capital, which includes common equity and disclosed reserves. Basel II requires an 8% capital-to-risk-weighted asset ratio, while Basel III requires 10.5%, with a 2.5% conservation buffer. 

  2. Calculate the Tier-2 capital, which includes items such as undisclosed reserves and subordinated debt.

  3. Add the capital from Tier-1 and Tier-2 together to determine the entire capital. CAR is measured using Tier-1 and Tier-2 capital, where Tier-1 capital comprises core finances and Tier-2 capital is a backup funding source.

  4. Evaluate the risk-weighted assets, which gives various asset classes distinct risk weights following their credit risk. Risk-weighted assets help banks and organizations stay afloat by setting a minimum capital requirement.

  5. The CAR is determined by dividing total capital by risk-weighted assets. The capital adequacy ratio ensures banks maintain enough funds to cushion a reasonable share of losses before the collapse.

The ratio determines the resilience of a firm's finances and the soundness of the bank to sustain losses.

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Is It Good If the Capital Adequacy Ratio Is High?

Generally, a high CAR is seen favorably as it shows that the bank is resilient to financial shocks and has adequate capital. A very high CAR, however, may also indicate that the bank is not making as much money as it could be since it is not taking enough chances.

A bank's ideal CAR is contingent upon several elements, including the bank's dimensions, risk appetite, and regulatory framework. But generally speaking, a CAR of about 10% is sufficient.

Here are some of the benefits of a high CAR:

  • Increased financial stability: A high CAR can help to protect a bank from financial shocks, such as a recession or a sudden increase in loan defaults.

  • Reduced risk of failure: A high CAR can help reduce the risk of a bank failing, protecting depositors and other creditors.

  • Improved access to funding: A high CAR can make borrowing money from other banks and financial institutions easier for a bank.

  • Enhanced investor confidence: Higher stock prices may result from increased investor trust in a bank, aided by a high CAR.

Generally, a bank benefits from having a high CAR. It's crucial to remember, though, that a very high CAR may also indicate that the bank is not making as much money as it could be because it is not taking enough chances.

What If the Capital Adequacy Ratio Is Low?

An insufficient capital adequacy ratio means the bank needs more capital to cover potential losses. The bank's ability to repay creditors and depositors during a financial crisis could be a concern.

  • A low capital adequacy ratio signals heightened risk within the bank, potentially eroding investor and depositor confidence.

  • It may trigger regulatory scrutiny and intervention to address the deficiency.

  • The bank might be required to raise additional capital through stock issuance or asset sales to bolster its reserves.

  • A low ratio could limit the bank's capacity to lend, constraining its ability to support economic activities.

  • Market perception of the bank's stability and creditworthiness may be negatively impacted, affecting its ability to attract deposits and investors.

  • A low capital adequacy ratio poses significant challenges to the bank's financial health and operational flexibility.

The capital adequacy ratio of a bank might be low for several reasons. For one thing, the bank could have given out too many hazardous loans. A further explanation might be that the bank's asset worth has decreased.

A bank could have to take action to raise capital if its capital adequacy ratio is low. This might entail selling assets, lowering its risk-weighted asset count, or obtaining fresh funding from investors.

Why Is the Capital Adequacy Ratio Important?

The Capital Adequacy Ratio (CAR) is vital for several reasons:

Financial Stability: 

It stabilizes the financial system by ensuring banks and other financial institutions maintain a sufficient capital buffer against potential losses.

Regulatory Compliance:

One of the institutions' most stringent regulatory responsibilities, such as the Basel Committee on Banking Supervision, requires banks to maintain a minimum ratio of capital to risk-weighted assets.

Risk Management:

Ratios of minimum capital adequacy are essential. They can show whether specific banks have sufficient capital to withstand a certain level of loss, preventing them from going bankrupt and losing depositor money.

Maintain Stability:

Capital adequacy ratios can improve a nation's financial system's efficacy and stability by lowering the risk of bank collapse. When processing payments, a bank with a high capital adequacy ratio is frequently considered reliable and safe.

Protection for Depositors:

Depositor funds are prioritized throughout the winding-up procedure over the bank's capital. Thus, depositors' funds are safe unless a bank accumulates more loss than its capital. Therefore, the higher the bank's capital adequacy ratio, the stronger the asset protection for depositors.

Investor Confidence:

The bank's capacity to withstand economic downturns is bolstered by a strong CAR, which communicates to stakeholders and investors that the bank has a solid financial base.

Lending Capacity: 

Adequate capital levels enable banks to support lending activities, fostering economic growth and stability within the financial system.

Final Words

The capital adequacy ratio, or CAR, analyzes a bank's risk-weighted assets concerning its available capital. A low ratio reveals a bank's vulnerability to losses. The bank's projected ability to fend off any setbacks rises in tandem with the ratio. 

The ratio quickly indicates a bank's capacity to cover losses and preserve its solvency during difficult financial circumstances. With an extra 2.5% conservation buffer, the minimum CAR values required by Basel II are 8.0%, and Basel III is 10.5%. A bank should be more able to fulfill its financial obligations under pressure if its CAR is higher. 

FAQs

What is the allowed minimum capital adequacy ratio?

The Basel II agreement states that 8% is the minimum. It is 10.5% after the Basel III accord and a 2.5% additional conservation buffer.23 The Federal Deposit Insurance Company (FDIC) of the United States mandates that the ratio of total capital to total risk-weighted assets must not be less than 8%.

Why Is the Goal of Capital Adequacy Ratio?

The goal of the capital adequacy ratio is to guarantee that banks have sufficient cash on hand to absorb a fair amount of losses and avoid going bankrupt.

How do banks increase the capital adequacy ratio?

Banks can lower their risk-weighted assets or raise additional capital to raise their capital adequacy ratio. This can be accomplished by taking steps such as selling non-core assets, issuing additional shares, or holding onto earnings. Banks may enhance their financial situation and raise their capital adequacy ratio by either growing their capital base or reducing the quantity of hazardous assets they hold

What is the minimum capital adequacy ratio to be maintained?

Basel III regulations require a minimum capital adequacy ratio of 8%. According to this regulation, the minimum capital banks must keep on hand to protect themselves from potential losses is 8% of their risk-weighted assets. Following this standard is essential to guarantee the resilience and stability of banks, protecting the more extensive financial system from systemic risks and boosting investor and depositor confidence in the banking industry.

What does a high capital adequacy ratio mean?

The formula-based Capital Adequacy Ratio (CAR) measures Basel II and Basel III mandates a minimum of 8.0% and 10.5% for CAR values, respectively, along with an extra 2.5% for conservation buffer. A bank should be more able to fulfill its financial obligations under pressure if its CAR is greater.

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19 Dec, 2023

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