Capital adequacy ratio
Encyclopedia
Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR), is a ratio
of a bank
's capital
to its risk
. National regulators
track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirement
s.
expressed as a percentage
of its assets weighted credit
exposures.
Capital adequacy ratio is defined as
TIER 1 CAPITAL -A)Equity Capital, B) Disclosed Reserves
TIER 2 CAPITAL -A)Undisclosed Reserves, B)General Loss reserves, C)Subordinate Term Debts
where Risk
can either be weighted asset
s (
) or the respective national regulator's
minimum total capital
requirement. If using risk weighted asset
s,
≥ 10%.
The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator of different countries.
Two types of capital are measured: tier one capital
(
above), which can absorb losses without a bank
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.
risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and 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
of debt
-to-equity
leverage formulations (although CAR uses equity over assets instead of debt
-to-equity; since asset
s are by definition equal to debt
plus equity, a transformation is required). Unlike traditional leverage
, however, CAR recognizes that assets can have different levels of risk
.
y 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 Accord
s. In the most basic application, government
debt
is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR.
Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the credit conversion factor. This will then have to be again multiplied by the relevant weightage.
Local regulations
establish that cash
and government bonds have a 0% risk weighting, and residential mortgage loan
s have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting.
Bank "A" has assets totaling 100 units, consisting of:
Bank "A" has debt of 95 units, all of which are deposits. By definition, equity
is equal to assets minus 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
ratio
of 95:5, or equity-to-assets of only 5%, its CAR is substantially higher. It is considered less risk
y because some of its assets are less risky than others.
recognize that different types of equity are more important than others. To recognize this, different adjustments are made:
Different minimum CAR ratios are applied: minimum Tier I
equity
to risk
-weighted assets 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
.
Ratio
In mathematics, a ratio is a relationship between two numbers of the same kind , usually expressed as "a to b" or a:b, sometimes expressed arithmetically as a dimensionless quotient of the two which explicitly indicates how many times the first number contains the second In mathematics, a ratio is...
of a bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
's capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
to its risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
. National regulators
Bank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...
track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirement
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...
s.
Formula
Capital adequacy ratios ("CAR") are a measure of the amount of a bank's core capitalTier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...
expressed as a percentage
Percentage
In mathematics, a percentage is a way of expressing a number as a fraction of 100 . It is often denoted using the percent sign, “%”, or the abbreviation “pct”. For example, 45% is equal to 45/100, or 0.45.Percentages are used to express how large/small one quantity is, relative to another quantity...
of its assets weighted credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
exposures.
Capital adequacy ratio is defined as
TIER 1 CAPITAL -A)Equity Capital, B) Disclosed Reserves
TIER 2 CAPITAL -A)Undisclosed Reserves, B)General Loss reserves, C)Subordinate Term Debts
where Risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
can either be weighted asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s (
) or the respective national regulator'sBank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...
minimum total capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
requirement. If using risk weighted asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s,
≥ 10%.The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator of different countries.
Two types of capital are measured: tier one capital
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...
(
above), which can absorb losses without a bankBank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
being required to cease trading, and tier two capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
(
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 bank's capacity to meet the time liabilities and other risks such as creditCredit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders. Banking regulators
Bank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...
in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
CAR is similar to leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
; in the most basic formulation, it is comparable to the inverse
Inverse
Inverse may refer to:* Inverse , a type of immediate inference from a conditional sentence* Inverse , a program for solving inverse and optimization problems...
of debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
-to-equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
leverage formulations (although CAR uses equity over assets instead of debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
-to-equity; since asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s are by definition equal to debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
plus equity, a transformation is required). Unlike traditional leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
, however, CAR recognizes that assets can have different levels of risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
.
Risk weighting
Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less riskRisk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
y by allowing banks to "discount" lower-risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
assets. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accord
Basel Accord
The Basel Accords refer to the banking supervision Accords —Basel I and Basel II issued and Basel III—by the Basel Committee on Banking Supervision ....
s. In the most basic application, government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR.
Risk weighting example
Risk weighted assets - Fund Based : Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets.Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the credit conversion factor. This will then have to be again multiplied by the relevant weightage.
Local regulations
Bank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...
establish that cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
and government bonds have a 0% risk weighting, and residential mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting.
Bank "A" has assets totaling 100 units, consisting of:
- CashCashIn common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
: 10 units - Government bonds: 15 units
- Mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s: 20 units - Other loans: 50 units
- Other assets: 5 units
Bank "A" has debt of 95 units, all of which are deposits. By definition, equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
is equal to assets minus debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
, or 5 units.
Bank A's risk-weighted assets are calculated as follows
| Cash |  |
| Government securities |  |
| Mortgage loans |  |
| Other loans |  |
| Other assets |  |
| Total risk | |
|---|---|
| Weighted assets | 65 |
| Equity | 5 |
| CAR (Equity Ownership equity In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists... /RWA) |
7.69% |
Even though Bank "A" would appear to have a debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
-to-equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
ratio
Ratio
In mathematics, a ratio is a relationship between two numbers of the same kind , usually expressed as "a to b" or a:b, sometimes expressed arithmetically as a dimensionless quotient of the two which explicitly indicates how many times the first number contains the second In mathematics, a ratio is...
of 95:5, or equity-to-assets of only 5%, its CAR is substantially higher. It is considered less risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
y because some of its assets are less risky than others.
Types of capital
The Basel rulesBasel Accord
The Basel Accords refer to the banking supervision Accords —Basel I and Basel II issued and Basel III—by the Basel Committee on Banking Supervision ....
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 subordinated debtSubordinated debtIn finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....
.
Different minimum CAR ratios are applied: minimum Tier I
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...
equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
to risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
-weighted assets may be 4%, while minimum CAR including Tier II capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
may be 8%.
There is usually a maximum of Tier II capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
that may be "counted" towards CAR, depending on the jurisdiction
Jurisdiction
Jurisdiction is the practical authority granted to a formally constituted legal body or to a political leader to deal with and make pronouncements on legal matters and, by implication, to administer justice within a defined area of responsibility...
.
External links
- Capital Adequacy Ratio at Investopedia.