The Capital Adequacy Ratio (CAR), also known as the Capital to Risk (Weighted) Assets Ratio (CRAR), is a measure of a bank's financial strength, expressed as a ratio of its capital to its risk-weighted assets and current liabilities. This financial metric is used globally to safeguard depositors and enhance the efficiency and stability of financial systems.
This concept plays a crucial role in the economics section of the UPSC exam .
The CAR or the CRAR is determined by dividing the bank's capital by the aggregate risk-weighted assets for credit risk, operational risk, and market risk.
The calculation involves adding a bank's tier 1 capital and tier 2 capitals and dividing the sum by its total risk-weighted assets. The formula is as follows:
Tier 1 CAR = (Eligible Tier 1 capital funds) ÷ (Market Risk RWA + Credit Risk RWA + Operational Risk RWA)
Total CAR = (Eligible Total capital funds) ÷ (Credit Risk RWA + Market Risk RWA + Operational Risk RWA)
CAR = (Tier 1 capital + Tier 2 capital)/risk weighted assets
The two types of capitals considered in this calculation are:
Tier 1 capital: This capital type can absorb losses without the bank having to cease operations. It includes ordinary share capital, equity capital, audited revenue reserves, and intangible assets.
Tier 2 capital: This type of capital can absorb losses in the event of the bank's liquidation, providing less protection to depositors. It includes unaudited reserves, unaudited retained earnings, and general loss reserves.
Risk-weighted assets: These are assets used to determine the minimum capital that banks should hold to reduce the risk of insolvency. The required capital for all types of bank assets is based on risk assessment.
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The CAR is set by central banks and banking regulators to prevent commercial banks from over-extending themselves and becoming insolvent as a result. It ensures that banks have enough buffer to absorb a reasonable amount of losses before becoming insolvent, thereby protecting depositors' funds.
A bank with a high CRAR/CAR is generally considered safe and likely to meet its financial obligations.
In the event of a bank's liquidation, depositors' funds are given higher priority than the bank's capital, meaning depositors will only lose their savings if the bank's losses exceed its capital. Therefore, the higher the CAR, the greater the protection for depositors' funds.
The CAR plays a crucial role in maintaining the stability of an economy's financial system by ensuring that the risk of banks becoming insolvent is low.
According to Basel III Norms, a CAR of 8% is prescribed. However, in India, the Reserve Bank of India ( RBI ) mandates a CAR of 9% for scheduled commercial banks, while public sector banks are required to maintain a CAR of 12%.
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