Capital Adequacy Ratio

Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine the adequacy of their capital keeping in view their risk exposures. Banking regulators require a minimum capital adequacy ratio so as to provide the banks with a cushion to absorb losses before they become insolvent. This improves stability in financial markets and protects deposit-holders. Basel Committee on Banking Supervision of the Bank of International Settlements develops rules related to capital adequacy which member countries are expected to follow.

The committee's latest pronouncement on capital adequacy is Basel III, issued December 2010, revised June 2011. Complete text is available here.

The pronouncement requires banks to maintain the following minimum ratios as of 1 January 2013:

Common Equity Tier 1 ÷ Risk-weighted Exposures3.5%
Tier 1 Capital ÷ Risk-weighted Exposures4.5%
Total Capital ÷ Risk-weighted Exposures8%

Since such pronouncements are frequently updated, please consult the Bank of International Settlements website for latest guidance.

Formula

Capital Adequacy Ratio =Tier 1 Capital + Tier 2 Capital
Risk-weighted Exposures

Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1

Total Capital = Tier 1 Capital + Tier 2 Capital

Risk-weighted exposures include weighted sum of the banks credit exposures (including those appearing on the bank's balance sheet and those not appearing). The weights are determined in accordance with the Basel Committee guidance for assets of each credit rating slab.

Example

Calculate capital adequacy ratio i.e. total capital to risk weighted exposures ratio for Small Bank Inc. using the following information:

ExposureRisk Weight
Government Treasury held as asset1,500,0000%
Loans to Corporates15,000,00010%
Loans to Small Businesses8,000,00020%
Guarantees and other non-balance sheet exposures6,000,00010%

The bank's Tier 1 Capital and Tier 2 Capital are $200,000 and $300,000 respectively.

Solution

Banks's total capital = 200,000 + 300,000 = $500,000

Risk-weighted exposures = $1.5×0% + $15×10% + $8×20% + $6×10% = $3.7 million

Capital Adequacy Ratio =$0.5 million= 14%
$3.7 million

If the national regulator requires a capital adequacy ratio of 10%, the bank is safe. However, if the required ratio is 15%, the bank might have to face regulatory actions.

Please note that guarantees and other non-balance sheet exposures are included in the calculation of risk-weighted exposures.

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork