Capital Adequacy Ratio (CAR) – Meaning, Formula and Advantages
Capital adequacy ratio (CAR), also known as capital-to-risk weighted assets ratio (CRAR) measures a bank’s available capital in relation to its current assets and liabilities. CAR is important to ensure that a bank has an adequate financial cushion to absorb losses before it declares insolvency.
In this piece, we have dissected CAR in detail, its importance in the Indian banking system and how it is calculated.
What is Capital Adequacy Ratio?
The capital adequacy ratio (CAR) is a ratio between a bank’s accumulated capital and risk-weighted assets. CAR is a critical metric to assess a bank’s financial standing. The CAR is decided by central banks and regulators to prevent private banks from becoming insolvent.
Expressed as a percentage, the CAR considers both tier-1 and tier-2 capitals. Tier-1 capital includes a shareholder’s stake and an institution’s retained earnings, while tier-2 capital includes reserves and hybrid securities. As tier-1 capitals are more liquid than tier-2 capitals, they can absorb losses incurred in business operations.
Risk-weighted assets measure the risk-augmented assets like cash, bonds, etc. Risk is weighed by following an asset’s potential to decrease in value. Government debts, for example, bear negligible risks, while those with little or no collaterals are riskier.
Why is Capital Adequacy Ratio Important?
Banks fear insolvency and non-performing assets. A high capital adequacy ratio for banks acts like a cushion to absorb excessive risks and prevent insolvency.
Central banks and financial regulators set the ratio in such a way that banks can digest risk-bearing elements. Normally, banks have enough reserves to ease out losses, thus preventing them from losing customer deposits.
Experts consider banks with high CAR values as healthy and able enough to continue their financial operations. Lower values indicate assets are growing riskier, thereby threatening the bank’s capital.
Capital continues to lose value because of the bank’s obligation to safeguard the depositor’s funds. For example, as of 2022, the Bank of India has filed an insolvency plea against Future Retail Ltd., indicating the latter’s inability to pay off debts hurting BOI’s capital foundation.
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Capital Adequacy Ratio Formula
The mathematical representation of the capital adequacy rate is as follows:
CAR = Total Capital / Risk-Weighted assets
where, Total capital = Tier-1 capital + Tier-2 capital of the bank, and risk-weighted assets are the bank’s cash balances, corporate loans, other loans, etc.
High CAR values indicate banks have enough capital to minimise damage caused by risk-bearing assets. Lower values may indicate that banks are suffering from multiple non-performing assets and gradually emerging into insolvency.
How to Calculate the Capital Adequacy Ratio (CAR)?
Let’s calculate the CAR of a financial institution by using the formula stated above. Suppose a bank ABC has Rs.100 crore in tier-1 capital and Rs.50 crore in tier-1 capital. The value of its risk weighted-assets, such as loans, is Rs.500 crore. Thus, the CAR of the bank would be:
Total Capital / Risk-Weighted assets = Rs. [(100+50)/500] = 0.3 or 30%.
The international regulatory framework Basel III requires banks to maintain a minimum capital adequacy ratio of 10.5%. Thus, 30% is deemed as a good CAR for the financial institution.
The Reserve Bank of India oversees the implementation of CAR in India with a minimum prerequisite of 9% for scheduled commercial banks and 12% for public-sector commercial banks.
As an example, the Indian Bank recorded a CAR of 12.55% in 2018, falling from 13.64% in 2017. This indicates an increase in the riskiness of its assets against its capital for that financial year.
What is the current Capital Adequacy Ratio in India?
The capital adequacy norms in the Indian public sector banking system thrive to maintain a decent CAR to maintain enough solvency. As of 2022, Bandhan bank has shown promising results with its current CAR at 19.4% despite its Quarter-1 profits doubling to Rs.887 crore.
The State Bank of India struggles to maintain its CAR at 13.3%, although stress test results reveal that it can fall to 11.8%. The COVID-19 pandemic has hit the banking system at its core owing to large public debts and the inability of investors to pay off debts due to insufficient demand.
Banks are increasingly raising more capital to sustain a decent CAR value to maintain bank capital adequacy. As of 2021, the ICICI Bank plans to raise Rs. 15,000 crores to cushion its growing non-performing assets.
What are the Advantages of Capital Adequacy Ratio?
The capital adequacy ratio for banks measures their power to hold on to assets and prevent their insolvency. Some advantages of the capital adequacy ratio include:
- CAR allows regulators like RBI to prevent all commercial banks from accepting excess leverage to cover their risk-weighted assets by assessing this ratio.
- CAR is an indicator of a bank’s financial progress. It measures its ability to sustain losses until it starts losing customer deposits.
- CAR indicates a bank’s financial obligations. With a CAR of 17.9%, HDFC Bank records a fall in its risk-weighted asset compared to its aggregate capital.
- The RBI considers CAR an important statistic for detecting and lowering a bank’s insolvency requests.
What are the Disadvantages of Capital Adequacy Ratio?
The only drawback would be that during economic turmoil like inflation and liquidity traps, CAR cannot measure expected losses, which, in turn, can dent the bank’s capital.
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Final Word
Banks regard customers’ deposits more in times of dissolution or insolvent conditions. The capital adequacy ratio signals the incidence of such conditions and warns banking institutions against accepting assets with too many risks.
FAQs
Ans. Basel III requires banking institutions to maintain at least 8% CAR. However, it is set at 10.35% if banks include the capital conservation buffer. A higher ratio indicates a more comfortable position to uphold customer deposits and prevent insolvency.
Ans. The tier-1 capital of a banking institution, also known as core capital, can absorb losses without stopping financial activities. They are permanently available for transactions and are used to dampen losses in case of insolvent conditions.
Ans. As of 2022, RBI has stated that banks with deposits of more than Rs. 100 crore must maintain a minimum CAR of 12% from a previously maintained 9%. However, RBI plans to adopt a four-tiered regulatory framework that would check the financial soundness of Indian banks.
Ans. Assets that do not show any chances of payment by the borrower to the concerned bank are non-performing. Higher NPAs mean greater risk in terms of asset quality. It can also affect other statistics like the capital adequacy ratio.
Ans. Tier I capital of a bank denotes the share capital and disclosed reserves. It is a bank’s highest quality capital because it is fully available to cover losses. On the other hand, Tier II capital consists of certain types of subordinated debt and reserves.
