Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital in relation to its risk-weighted assets and current liabilities. It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
In other words, it measures how much capital does a bank has with it as a percentage of its total credit exposure. Bank regulators enforce this ratio to ensure credit discipline in order to protect depositors and promote stability and efficiency in the financial system.
The formula used to measure Capital Adequacy Ratio is = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets)
Here Tier I capital is a bank’s core capital consisting of shareholders’ equity and retained earnings; while Tier II capital includes revaluation reserves, hybrid capital instruments, and subordinated term debt. Tier III capital consists of Tier II capital plus short-term subordinated loans.
The risk-weighted assets take into account credit risk, market risk and operational risk.
As of 2019, under Basel III, a bank’s tier 1 and tier 2 capital must be at least 8 per cent of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5 per cent. The capital conservation buffer recommendation is designed to build up banks’ capital, which they could use in periods of stress.
Source: Economic Times