By : Neha Dhyani
Updated : Mar 29, 2022, 8:18
The Capital Adequacy Ratio (CAR) is a measure that sets standards for banks by evaluating and analyzing their ability to pay liabilities and also respond to credit risks and operational risks. When a bank's objective is to secure the potential depositors, it needs to have enough capital to absorb potential losses. This also reduces the risk of being insolvent and losing depositors' money.
CAR is also known as CRAR, Capital to Risk-weighted Assets Ratio. In other words, it is the ratio of the bank's capital to its risky assets and current liabilities and thus has a secured financial system. It is evaluated by dividing the total capital of any bank by the gross risk-weighted assets involving credit risk, operational risk, and market risks.
The Capital Adequacy Ratio is evaluated by dividing a bank's capital by its risk-weighted assets. The bank's capital is divided into two tiers, tier 1 and tier 2.
Tier 1 capital consists of a bank's core capital, which includes the share and equity capital, incorporeal assets, and audited revenue reserves. Normally a bank uses this kind of capital to absorb losses so that it does not affect the general operation of the bank. The ordinary share capital can be considered a perfect example of this kind of capital.
Tier 2 capital encompasses the unaudited and unaccounted retained earnings and reserves. When any company is liquidating or winding up, this kind of capital absorbs the losses. Generally, when the tier 1 capital is all over, the bank uses this capital, which is why the degree of protection to the creditors and depositors is less here.
Risk-weighted assets can be considered as the minimal amount of capital that financial institutions must hold to prevent the risk of insolvency. Say, for instance, a loan secured by a letter of credit is considered riskier and requires more capital than a mortgage loan that is protected with security.
The formula for working out Capital Adequacy Ratio is:
CAR= (Tier 1 capital +Tier 2 capital) / risk-weighted assets.
Any bank or financial institution needs to ensure sufficient capacity to cushion a reasonable amount of losses and prevent insolvency and risk to depositor's funds. The higher the bank's CAR, the higher is the degree of protection of depositor's assets.
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The Capital Adequacy Ratio (CAR) is the Capital Risk-weighted Assets Ratio (CRAR) ratio of a bank's capital to its risk.
Ans: CAR is important to ensure that it can tactfully absorb losses and comply with statuary Capital requirements with ease.
Ans: The formula for working out CAR is:
CAR= (Tier 1 capital +Tier 2 capital) / risk-weighted assets.
As per RBI norms, Indian scheduled commercial banks to be 9%, and for public sector banks, the CAR to be maintained is 12%.