Capital Adequacy Ratio – CAR
Contents
Understanding Capital Adequacy Ratio (CAR) in Banking: A Comprehensive Guide
The Capital Adequacy Ratio (CAR) is a crucial metric for assessing a bank's financial health and stability. In this detailed guide, we explore the intricacies of CAR, its calculation methods, significance, and limitations, providing valuable insights into the world of banking regulations and risk management.
Calculating CAR
CAR is computed by dividing a bank's capital (comprising tier-1 and tier-2 capital) by its risk-weighted assets. Tier-1 capital absorbs losses without requiring the bank to halt operations, while tier-2 capital provides additional cushioning in case of liquidation.
Tier-1 Capital
Tier-1 capital consists of equity capital, ordinary share capital, and other core components that can absorb losses without disrupting bank operations.
Tier-2 Capital
Tier-2 capital includes unaudited retained earnings and reserves, providing further protection in the event of bank winding-up.
Risk-Weighted Assets
Risk-weighted assets determine the minimum capital requirement based on the risk assessment of each bank asset. Loans are weighted based on their credit risk, with adjustments made for off-balance sheet exposures.
Why CAR Matters
CAR ensures that banks have sufficient reserves to absorb losses and maintain financial stability. Higher CARs indicate greater safety and reliability for depositors, reducing the risk of insolvency and protecting depositor assets.
Example of Using CAR
Illustrating with a hypothetical scenario, we demonstrate how CAR is calculated and its implications for bank safety and solvency.
Comparing CAR with Solvency Ratio
While CAR is specific to evaluating banks, the solvency ratio assesses a company's ability to cover its financial obligations. Both metrics offer valuable insights into financial health and risk management.
Exploring Tier-1 Leverage Ratio
The tier-1 leverage ratio measures a bank's core capital against its total assets, providing an additional perspective on financial resilience.
Limitations of CAR
Despite its significance, CAR may overlook expected losses during financial crises, leading some experts to advocate for the use of economic capital as a more comprehensive risk assessment tool.