Table of Contents
- What Is the Capital Adequacy Ratio (CAR)?
- Key Takeaways
- Understanding CAR
- Types of Capital
- Common Equity Tier-1 Capital
- Additional Tier 1 Capital
- Tier-2 Capital
- Risk-Weighted Assets
- The CAR Formula
- Example
- Why the Capital Adequacy Ratio Matters
- CAR vs. the Solvency Ratio
- CAR vs. Tier-1 Leverage Ratio
- Limitation of Using CAR
- What Are the Basel Accords?
- What's the Minimum Capital Adequacy Ratio Allowed?
- What's the Purpose of the Capital Adequacy Ratio?
- The Bottom Line
What Is the Capital Adequacy Ratio (CAR)?
Let me explain the capital adequacy ratio (CAR) directly: it's a measure of how much capital a bank holds in relation to its risk-weighted assets. You might also hear it called the capital-to-risk weighted assets ratio (CRAR), and regulators keep a close eye on it to gauge a bank's risk of failing. This ratio exists to safeguard depositors and maintain the stability and efficiency of financial systems globally.
Key Takeaways
You need to know that CAR is essential for banks to have a sufficient buffer to handle reasonable losses without going insolvent. Regulators rely on it to assess capital adequacy and perform stress tests. It incorporates both Tier 1 and Tier 2 capital in its calculation. However, remember that CAR doesn't factor in risks like a bank run or what might occur during a financial crisis.
Understanding CAR
CAR helps banks manage risk by ensuring they hold enough capital to cover potential losses. You calculate it by dividing the bank's capital by its risk-weighted assets. According to current Basel rules, banks must always meet these thresholds: Common Equity Tier 1 at least 4.5% of risk-weighted assets (RWA), Tier 1 capital at least 6% of RWA, and total capital at least 8.0% of RWA.
A minimum CAR is vital because it provides a cushion for absorbing losses before a bank becomes insolvent and risks depositors' funds. The capital for this ratio splits into two tiers, which you add together and divide by risk-weighted assets. Those assets get weighted based on the risk of the bank's loans—adjustments are made to balance sheet values accordingly.
All loans from the bank are weighted by their credit risk level. For instance, government loans might get a 0.0% risk weight, while personal loans could be at 100.0%, indicating higher risk.
Types of Capital
There are three main types of capital involved: Common Equity Tier 1, Additional Tier 1, and Tier 2 Capital. I'll break them down for you.
Common Equity Tier-1 Capital
Tier-1 capital, or core capital, includes common shares issued by the bank, stock surplus from other Tier 1 instruments, retained earnings, and other comprehensive income. It also covers common shares from subsidiaries held by minority shareholders. This is the capital that's always available to absorb losses without halting bank operations.
Additional Tier 1 Capital
Additional Tier 1 includes non-common equity assets that can absorb losses without disrupting operations, like perpetual bonds and hybrid debt without maturity dates, where payments are at the bank's discretion. These must be subordinate to depositors and other creditors, meaning they're last in line during liquidation. It also includes similar instruments from subsidiaries and related stock surplus.
Tier-2 Capital
Tier-2 is gone-concern capital, absorbing losses if the bank fails. It consists of long-term debt and hybrid securities maturing over five years, subordinate to depositors and creditors. In a crisis, the bank can write this off or convert it to common equity. It includes stock surplus from Tier 2 assets or qualifying subsidiary issues.
Risk-Weighted Assets
Risk-weighted assets determine the minimum capital banks need to hold to avoid insolvency, based on risk assessments of each asset type. For example, a loan backed by a letter of credit is riskier than a mortgage secured by property, so it requires more capital.
Off-balance sheet items like foreign exchange contracts and guarantees carry credit risks too. You convert these to credit equivalents and weight them like on-balance sheet exposures, then add them up for total risk-weighted credit exposures.
The CAR Formula
The formula is straightforward: CAR equals (Tier 1 Capital + Tier 2 Capital) divided by Risk-Weighted Assets.
Example
Take Acme Bank with $20 million in Tier-1 capital and $5 million in Tier-2 capital, plus $65 million in weighted loans. Its CAR is 38% (($20 million + $5 million) / $65 million). That's a high ratio, meaning Acme Bank can likely handle a downturn and associated loan losses without becoming insolvent, more so than banks below minimum CARs.
Why the Capital Adequacy Ratio Matters
Minimum CARs are crucial as they show if banks can absorb losses without insolvency, protecting depositors' funds. Overall, high CARs enhance a nation's financial system stability by reducing bank collapse risks. A bank with a high CAR is seen as safe and reliable for meeting commitments.
In winding up, depositors get priority over bank capital, so they're only at risk if losses exceed capital. Thus, a higher CAR means better protection for depositors. All in all, a high CAR indicates a healthy bank ready to fulfill obligations.
CAR vs. the Solvency Ratio
Both CAR and the solvency ratio evaluate a company's ability to meet obligations, but CAR specifically applies to banks for handling loan-related losses. The solvency ratio checks if a company has enough cash for short- and long-term debts, with ratios below 20% signaling default risk. Analysts prefer it for measuring actual cash flow over net income, best for comparing similar firms in debt-heavy industries.
CAR vs. Tier-1 Leverage Ratio
The Tier-1 leverage ratio relates to CAR by comparing core capital to total assets, calculated as Tier-1 capital divided by average consolidated assets plus off-balance sheet exposures. A higher ratio means better resilience to balance sheet shocks.
Limitation of Using CAR
One key limitation is that CAR doesn't account for expected losses in a bank run or crisis, which can skew capital and costs. Many experts view economic capital as a better gauge of financial soundness, factoring in health, credit rating, expected losses, and solvency confidence for a more realistic risk assessment.
What Are the Basel Accords?
These are three regulatory agreements from the Basel Committee on Bank Supervision, addressing capital, market, and operational risks to ensure institutions hold enough capital for unexpected losses.
What's the Minimum Capital Adequacy Ratio Allowed?
Under Basel rules, banks must maintain: Common Equity Tier 1 at 4.5% of RWA, Tier 1 at 6% of RWA, and total capital at 8.0% of RWA.
What's the Purpose of the Capital Adequacy Ratio?
It's to ensure banks have funds to manage reasonable losses and avoid insolvency.
The Bottom Line
CAR compares a bank's available capital to its risk-weighted assets, giving a snapshot of its ability to cover losses and stay solvent in tough times. The higher the CAR, the better positioned the bank is to handle stress. Remember, Basel rules set minimums: 4.5% for Common Equity Tier 1, 6% for Tier 1, and 8% for total capital of RWA.
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