Capital Adequacy Ratio

Introduction

• Capital Adequacy Ratio (CAR) is the ratio of total capital to total risk weighted assets in percentage terms. 
• CAR is the parameter to measure the financial soundness of the Bank. 
• It is also called Capital to Risk-weighted Asset Ratio (CRAR). 
• Risk Weighted Assets (RWA) are assets that have varying risk profiles. For instance, an asset-backed by collateral would carry lesser risks as compared to loans, which have no collateral. 
• RBI introduced the Capital to Risk-Weighted Assets Ratio (CRAR) systems for Indian Banks in the year 1992.

Significance of CAR

• CAR ensures that banks have sufficient capital to meet the risk of future loss while also protecting depositors and general creditors. 
• set standards for banks by looking at a bank’s ability to pay liabilities, and respond to credit risks and operational risks. 
• A bank that has a good CAR has enough capital to absorb potential losses.

Formula for calculating CAR

• CAR is calculated by dividing the Tier 1 and Tier 2 capital of banks by Risk-Weighted Assets. 

Tier 1 capital

• Tier 1 capital, often known as core capital, is the capital that permits a bank to withstand losses without having to close. 
• The most significant criterion for measuring a bank’s financial strength is Tier 1 Capital. 
• Tier 1 capital consists of reserves that are publicly available and appear on the bank’s financial statements. These include: Share Capital, Undistributed Profit, and Preference Share Capital. 
• Tier 1 capital will be more in the form of equities

Tier 2 capital

• Tier 2 Capital/Supplementary Capital is the capital that can absorb losses in the case of a bank’s failure, although it provides less protection to depositors. 
• Tier 2 capital refers to funds that are not reported on a bank’s financial statements. Tier 2 capital include: Subordinate Debt, Revaluation Reserve, General loan-loss reserves, and Hybrid (debt/equity) capital instruments. 
• Most of the Tier 2 capital is in the form of debts and reserves etc. 
• At the end of 1974, in the aftermath of serious disturbances in international currency and banking markets (failure of Bankhaus Herstatt in West Germany), the Basel Committee (Committee on Banking Regulations and Supervisory Practices) was established.