What is capital adequacy ratio?

[ecis2016.org] Explained in this article is the term capital adequacy ratio and what it signifies in the banking world

Among the many tools that help one measure the financial stability of a financial entity, is its  capital adequacy ratio.

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What is capital adequacy ratio?

Capital adequacy ratio (CAR) is the ratio of a bank’s available capital, in relation to the risks involved in terms of loan disbursement. In other words, capital adequacy ratio is the ratio of a bank’s capital in relation to its assets and liabilities.

A credit solvency maintenance tool used by banking authorities to help banks stay fiscally fit, capital adequacy ratio is also known as capital-to-risk weighted asset ratio (CRAR).

Banking regulators often ask banks to keep and maintain a certain percentage of their debt exposure as its assets. Known as the bank’s capital adequacy ratio, this rate is expressed in terms of percentage. In simple terms, capital adequacy ratio measures how much capital a bank has, as a percentage of its total debt exposure.

Purpose of capital adequacy ratio

National banking regulators like the Reserve Bank of India (RBI) and international banking norms like BASEL, provide for capital adequacy ratios for banks in order to prevent them from over-leveraging and becoming debt-laden in the process, without having enough liquidity that could act as a cushion in case of any monetary strain.

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This way, banking regulators enforce financial discipline among banks and maintain the overall health of the banking system, thereby, safeguarding the investment of the depositor.

Maintaining the capital-to-risk weighted asset ratio makes banks more resilient in the event of financial turmoil such as the one witnessed during the global financial crisis of 2008 or the more local non-banking finance crisis of 2019.

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Formula to measure capital adequacy ratio

The formula used calculate capital adequacy ratio is:

(Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets)

While measuring a bank’s capital adequacy ratio, there are three types of capital that are taken into account:

Tier-I capital: This is the asset lying with the bank that can help it to absorb any shock without winding up its operations. Tier-I capital is a bank’s core capital including the shareholders’ equity and retained earnings.

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Tier-II capital: This is the asset lying with the bank that can absorb losses in the event of it seeing closure. A bank’s Tier-II capital is made of revaluation reserves, hybrid capital instruments and subordinated term debt.

Tier-III capital: This is a mix of Tier-II capital and the short-term subordinated loans.

What is Basel-III?

An international regulatory standard, Basel-III establishes norms to supervise the banking sector.

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Capital adequacy ratio in 2022

Under Basel-III, banks have to maintain a minimum capital adequacy ratio of 8%, as of 2022. However, the minimum capital adequacy ratio, including the capital conservation buffer, is 10.5%. Under Basel-III norms, capital adequacy ratios are above the minimum requirements under the Basel-II accord.

While a lower capital adequacy rate will allow banks to lend more, it would also expose them to higher risks. Conversely, while a high capital adequacy rate will curb a bank’s capacity to lend, it will help them maintain fiscal health.

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