Capital Adequacy Ratio (CAR)

Capital Adequacy Ratio (CAR) is a ratio that regulators in the banking system use to watch bank's health, specifically bank's capital to its risk. Regulators in the banking system track a bank's CAR to ensure that it can absorb a reasonable amount of loss.

Regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.

Capital adequacy ratio is the ratio which determines the capacity of a bank in terms of meeting the time liabilities and other risk such as credit risk, market risk, operational risk, and others. It is a measure of how much capital is used to support the banks' risk assets.

Bank's capital with respect to bank's risk is the most simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's depositors or other lenders.

How is the Capital Adequacy Ratio CAR calculated?

The ratio is calculated by dividing Tier1 + Tier2 capital by the risk weighted assets.

                           Capital
Capital Adequacy Ratio = ------------
                             Risk

                           Tier1 + Tier2 capital
                       = -----------------------------
                            Risk Weighted Assets * 8%

Two types of capital are measured for this calculation. Tier one capital is the capital in the bank's balance sheet that can absorb losses without a bank being required to cease trading.

Tier two capital can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

What values does the Capital Adequacy Ratio CAR can take?

Minimum standard set by the Bank for International Settlements (BIS) is 8% (comprising 4% each of Tier 1 and Tier 2 capital).

Singapore's minimum CAR is more stringent set by default at 12% (comprising 8% Tier1 and 4% Tier 2).

Advantages of using the Capital Adequacy Ratio CAR

In early phases of Basel implementations, bank's capital adequacy was calculated as assets times ratio.  This approach did not take risk profiles of assets into account.  It is obvious that a bank should keep more capital in reserves for riskier assets.

Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. So, for example, in the most basic application, government debt is allowed a 0% "risk weighting".  This also means that government debt is subtracted from total assets for purposes of calculating the CAR.

On the other hand, investments in junior tranches of instuments collateralized with subprime mortgages are very risky, and woudl be assigned 100% risk weighting.

Other names related to the Capital Adequacy Ratio CAR

Capital adequacy ratio (CAR) is often also called Capital to Risk (Weighted) Assets Ratio (CRAR).

Other details related to the Capital Adequacy Ratio CAR

Tier 1 Capital: This is the bank's core capital comprising of share capital, disclosed reserves and minority interests. Some institutions expand this definition to include restricted forms of "equity-like" capital instruments.

Upper Tier 2 Capital: This is more stringent than that defined under BIS standards. This capital includes funds raised from hybrid and long-dated subordinated debt instruments which satisfy MAS conditions and a limited portion of the banks' unencumbered general provisions. Revaluation surpluses of bank's holdings in properties and equities are not allowed. Conventional subordinated debt or shorter term Tier3 debt instruments are also not allowed.

Risk-Weighted Assets: This includes the total assets owned. The value of each asset is assigned a risk weight (for example 100% for corporate loans and 50% for mortgage loans) and the credit equivalent amount of all off-balance sheet activities. Each credit equivalent amount is also assigned a risk weight.

Is there any other ratio related to this metric?

Yes, for example the following financial ratios are very often used together with the Capital Adequacy Ratio (CAR):

Return On Assets (ROA),

Return on Investment (ROI),

or the Return On Equity (ROE).