Capital Adequacy Ratio (CAR)

Published Feb 6, 2023

Definition of Capital Adequacy Ratio (CAR)

Capital Adequacy Ratio (CAR) is a measure used by financial regulators to assess the financial stability and safety of a bank. It is calculated as the ratio of a bank’s capital to its risk-weighted assets. The purpose of this ratio is to ensure that banks have adequate capital to cover their potential losses and maintain their ability to absorb unexpected losses.

It can be calculated by dividing a bank’s Tier 1 capital by its risk-weighted assets. Tier 1 capital refers to the core capital of a bank, which includes equity capital and disclosed reserves. Risk-weighted assets are assets that are assigned a risk weight based on their credit risk and other factors, such as market risk. The higher the risk weight of an asset, the more capital the bank is required to hold against it.

The formula for calculating the Capital Adequacy Ratio is as follows:

Capital Adequacy Ratio = Tier 1 Capital / Risk-Weighted Assets

Example

To illustrate this, let’s look at the example of ABC Bank. Suppose ABC Bank has USD 10 million in tier 1 capital and USD 100 million in risk-weighted assets. In that case, its CAR is 10% (i.e., 10 million /100 million). This means that the bank has 10% of its risk-weighted assets held as capital, which is considered a minimum level of capital for the bank to operate safely.

Why Capital Adequacy Ratio Matters

The Capital Adequacy Ratio is an important measure of a bank’s financial health. It is used by regulators to ensure that banks have enough capital to absorb losses and remain solvent in the event of an economic downturn. Banks with a low CAR are considered to be at risk of insolvency and are subject to stricter regulations. Thus, it is important for banks to maintain a healthy CAR in order to remain in compliance with regulatory requirements.