What Is Capital Adequacy Ratio – CAR?
The capital adequacy ratio (CAR) is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. The capital adequacy ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured: tier-1 capital, which can absorb losses without a bank being required to cease trading, and tier-2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
The capital adequacy ratio is calculated by dividing a bank’s capital by its risk-weighted assets. The capital used to calculate the capital adequacy ratio is divided into two tiers.
Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-1 capital is used to absorb losses and does not require a bank to cease operations. Tier-1 capital is the capital that is permanently and easily available to cushion losses suffered by a bank without it being required to stop operating. A good example of a bank’s tier one capital is its ordinary share capital.
Tier-2 capital comprises unaudited retained earnings, unaudited reserves and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating. Tier-2 capital is the one that cushions losses in case the bank is winding up, so it provides a lesser degree of protection to depositors and creditors. It is used to absorb losses if a bank loses all its Tier-1 capital.
Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured with collateral.