- Capital adequacy ratio
Capital adequacy ratio (CAR), also called
Capital toRisk (Weighted) AssetsRatio (CRAR), is a ratio of abank 'scapital to itsrisk . National regulators track abank 's "CAR" to ensure that it can absorb a reasonable amount of loss [Cite web | url=http://www.rbnz.govt.nz/finstab/banking/regulation/0091769.html | title=Capital adequacy ratios for banks - simplified explanation and example of calculation | publisher=Reserve Bank of New Zealand | accessdate=2007-07-10] and are complying with their statutoryCapital requirement s.Formula
Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a
percentage of itsrisk weighted credit exposures.Capital adequacy ratio is defined as
where
Risk can either be weightedasset s () or the respective national regulator's minimum totalcapital requirement. If using risk weightedasset s,≥ 8%.Cite web | url=http://www.investopedia.com/terms/c/capitaladequacyratio.asp | title=Capital Adequacy Ratio - CAR | publisher=
Investopedia | accessdate=2007-07-10]The percent threshold (8% in this case, a common requirement for regulators conforming to the
Basel Accords ) is set by the national banking regulator.Two types of
capital are measured: tier one capital ( above), which can absorb losses without abank being required to cease trading, and tier two capital ( above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.Use
Capital adequacy ratio is the ratio which determines the
capacity of the bank in terms of meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most simple formulation, a bank'scapital is the "cushion" for potential losses, which protect the bank's depositors or other lenders. Banking regulators in most countries define and monitor "CAR" to protect depositors, thereby maintaining confidence in the banking system.CAR is similar to leverage; in the most basic formulation, it is comparable to the
inverse ofdebt -to-equity leverage formulations (although CAR usesequity overassets instead ofdebt -to-equity ; sinceasset s are by definition equal todebt plusequity , a transformation is required). Unlike traditional leverage, however, CAR recognizes thatassets can have different levels ofrisk .Risk weighting
Since different types of
assets have differentrisk profiles , CAR primarily adjusts forassets that are less risky by allowing banks to "discount" lower-risk assets . The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply theBasel Accord s. In the most basic application,government debt is allowed a 0% "risk weighting" - that is, they are subtracted from totalassets for purposes of calculating the CAR.Risk weighting example
Local regulations establish that
cash andgovernment bonds have a 0% risk weighting, andresidential mortgage loan s have a 50% risk weighting. All other types ofassets (loans to customers) have a 100% risk weighting."Bank "A" has
assets totaling 100 units, consisting of:
*Cash : 10 units.
*Government bonds : 15 units.
*Mortgage loan s: 20 units.
* Otherloans : 50 units.
* Otherassets : 5 units."Bank "A" has deposits of 95 units, all of which are deposits. By definition,
equity is equal toassets minusdebt , or 5 units.Bank A's risk-weighted assets are calculated as follows:Even though "Bank "A" would appear to have a
debt -to-equity ratio of 95:5, orequity -to-assets of only 5%, its CAR is substantially higher. It is considered lessrisk y because some of itsassets are less risky than others.Types of capital
The Basel rules recognize that different types of equity are more important than others. To recognize this, different adjustments are made:
# Tier I Capital: Actual contributed equity plus retained earnings.
# Tier II Capital: Preferred shares plus 50% ofsubordinated debt .Different minimum CAR ratios are applied: minimum Tier I
equity torisk -weightedassets may be 4%, while minimum CAR including Tier II capital may be 8%.There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the
jurisdiction .ee Also
*
Capital requirement
*Tier 1 capital
*Tier 2 capital
*Basel accord sReferences
External links
* [http://www.investopedia.com/terms/c/capitaladequacyratio.asp Capital Adequacy Ratio] at
Investopedia .
* [http://www.rbnz.govt.nz/finstab/banking/regulation/0091769.html Capital Adequacy Ratio] at The Reserve Bank of New Zealand's website.
* [http://nuscho.com Texas Ratios and FDIC Scores]
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