What Is the Capital Adequacy Ratio?

The capital adequacy ratio (CAR) is an indicator of how well a bank can meet its obligations. Also known as the capital-to-risk weighted assets ratio (CRAR), the ratio compares capital to risk-weighted assets and is watched by regulators to determine a bank's risk of failure. It's used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured:

Tier-1 capital, core funds on hand to manage losses so that a bank can continue operating and,

Tier-2 capital, a secondary supply of funds available from the sale of assets once a bank closes down.

Understanding CAR

The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets. Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% (which includes a 2.5% conservation buffer) under Basel III. High capital adequacy ratios are those that are higher than the minimum requirements under Basel II and Basel III.

A minimum capital adequacy ratio is critical in ensuring that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors’ funds.

The capital used to calculate the capital adequacy ratio is divided into two tiers. The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans, evaluating the risk and then assigning a weight. When measuring credit exposures, adjustments are made to the value of assets listed on a lender’s balance sheet.

All of the loans the bank has issued are weighted based on their degree of credit risk. For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%.

Tier-1 Capital

Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-1 capital is the capital that is permanently and easily available to absorb and cushion losses suffered by a bank without it being required to stop operating.

Tier-2 Capital

Tier-2 capital comprises unaudited retained earnings, unaudited reserves, and general loss reserves. Tier-2 capital is the capital that absorbs and cushions losses in the case where a bank is winding up. As such, it provides a lesser degree of protection to depositors and creditors. It is used once a bank loses all its Tier-1 capital.

Risk-Weighted Assets

Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured by a house.

Off-balance sheet agreements, such as foreign exchange contracts and guarantees, also have credit risks. Such exposures are converted to their credit equivalent figures and then weighted in a similar fashion to that of on-balance sheet credit exposures. The off-balance sheet and on-balance sheet credit exposures are then added together to obtain the total risk-weighted credit exposures.

The CAR Formula

 $CAR = \dfrac{Tier~1~Capital + Tier~2~Capital}{Risk~Weighted~Assets}$CAR=Risk Weighted AssetsTier 1 Capital+Tier 2 Capital​

Example

Suppose Acme Bank has $20 million in tier-1 capital and $5 million in tier-2 capital. It has loans that have been weighted and calculated at $65 million. The capital adequacy ratio of Acme Bank is therefore 38% (($20 million + $5 million) / $65 million). A CAR of 38% is a high capital adequacy ratio. That means that Acme Bank should be able to weather a financial downturn and losses associated with its loans. It is less likely than banks with less than minimum CARs to become insolvent.

Why the Capital Adequacy Ratio Matters

• Minimum capital adequacy ratios are critical. They can reveal whether individual banks have enough financial cushion to absorb a reasonable amount of loss so that they don't become insolvent and consequently lose depositors’ funds.
• Broadly, the capital adequacy ratios can help ensure the efficiency and stability of a nation’s financial system by lowering the risk of banks collapsing. Generally speaking, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial commitments.
• During the winding up process, funds belonging to depositors are given a higher priority than the bank’s capital. So depositors are only at risk of losing their savings if a bank registers a loss that exceeds the amount of capital it possesses. Thus, the higher the bank’s capital adequacy ratio, the higher the degree of protection for depositors' assets.
  

CAR vs. the Solvency Ratio

Both the capital adequacy ratio and the solvency ratio provide ways to evaluate a company's ability to meet financial obligations.

However, the capital adequacy ratio is applied specifically to banks and measures their abilities to overcome financial losses related to loans they've made. The solvency ratio debt evaluation metric is used to measure whether a company has enough available cash to meet its own short- and long-term debt obligations. Solvency ratios below 20% indicate an increased likelihood of default.

Analysts often favor the solvency ratio because it measures actual cash flow rather than net income, not all of which may be readily available to a company to meet debt obligations. The solvency ratio is best used to compare debt situations of similar firms within the same industry, as certain industries tend to be significantly more debt-heavy than others.

CAR vs. Tier-1 Leverage Ratio

The tier-1 leverage ratio is related to the capital adequacy ratio. The tier-1 leverage ratio compares a bank's core capital with its total assets. It is calculated by dividing Tier-1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures. The higher the tier-1 leverage ratio is, the more likely a bank can withstand negative shocks to its balance sheet.

Limitation of Using CAR

• One limitation of CAR is that it fails to account for expected losses during a bank run or financial crisis that can distort a bank's capital and cost of capital.
• Many analysts and bank executives consider the economic capital measure to be a more accurate and reliable assessment of a bank's financial soundness and risk exposure than the capital adequacy ratio.
• The calculation of economic capital, which estimates the amount of capital a bank needs on hand to ensure its ability to handle its current outstanding risk, is based on the bank's financial health, credit rating, expected losses, and confidence level of solvency.
• By including such economic possibilities as expected losses, this measurement is thought to represent a more realistic appraisal of a bank's actual financial health and risk level.

The Bottom Line

CAR, or the capital adequacy ratio, is a comparison of the available capital that a bank has on hand to its risk-weighted assets. The ratio provides a quick idea of whether a bank has enough funds to cover losses and remain solvent under difficult financial circumstances. CAR minimums are 8.0% under Basel II and 10.5% (with an added 2.5% conservation buffer) under Basel III. The higher the CAR, the better able a bank should be to meet its financial obligations when under stress.