- Capital adequacy ratio
Capital adequacy ratio (CAR), also called
Capitalto Risk(Weighted) Assets Ratio(CRAR), is a ratio of a bank's capitalto its risk. National regulators track a bank'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 statutory Capital requirements.
Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a
percentageof its riskweighted credit exposures.
Capital adequacy ratio is defined as
Riskcan either be weighted assets () or the respective national regulator's minimum total capitalrequirement. If using risk weighted assets,
≥ 8%.Cite web | url=http://www.investopedia.com/terms/c/capitaladequacyratio.asp | title=Capital Adequacy Ratio - CAR | publisher=
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
capitalare measured: tier one capital ( above), which can absorb losses without a bankbeing 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.
Capital adequacy ratio is the ratio which determines the
capacityof 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's capitalis 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
inverseof debt-to- equityleverage formulations (although CAR uses equityover assetsinstead of debt-to- equity; since assets are by definition equal to debtplus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assetscan have different levels of risk.
Since different types of
assetshave different risk profiles, CAR primarily adjusts for assetsthat 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 the Basel Accords. In the most basic application, government debtis allowed a 0% "risk weighting" - that is, they are subtracted from total assetsfor purposes of calculating the CAR.
Risk weighting example
Local regulations establish that
cashand government bondshave a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets(loans to customers) have a 100% risk weighting.
"Bank "A" has
assetstotaling 100 units, consisting of:
Cash: 10 units.
Government bonds: 15 units.
Mortgage loans: 20 units.
loans: 50 units.
assets: 5 units.
"Bank "A" has deposits of 95 units, all of which are deposits. By definition,
equityis equal to assetsminus debt, 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 ratioof 95:5, or equity-to- assetsof only 5%, its CAR is substantially higher. It is considered less risky because some of its assetsare 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% of
There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the
Tier 1 capital
Tier 2 capital
* [http://www.investopedia.com/terms/c/capitaladequacyratio.asp Capital Adequacy Ratio] at
* [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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