What is the Capital Adequacy Ratio (CAR)?
– Definition: The capital adequacy ratio (CAR), also called the capital-to-risk-weighted-assets ratio (CRAR), shows the proportion of a bank’s capital relative to its risk-weighted assets (RWA). Regulators monitor CAR to assess how much of a loss-absorbing buffer a bank holds against credit and other risks.
Key components — short definitions
– Risk-weighted assets (RWA): A bank’s assets (loans, holdings, off‑balance-sheet exposures) are adjusted for credit risk by applying weights. Safer exposures get lower weights (for example, some sovereign exposures may carry a 0% weight) while unsecured retail loans may be weighted 100% or more depending on rules.
– Common Equity Tier 1 (CET1): The highest-quality capital. Includes common share capital, retained earnings, and other core reserves that are permanently available to absorb losses.
– Additional Tier 1 (AT1): Instruments that can absorb losses but are not common equity — for example, perpetual subordinated securities whose coupons can be skipped and principal written down in stress.
– Tier 2 capital: Subordinated debt and certain hybrid instruments that can absorb losses in resolution (gone‑concern capital), typically with long maturities and lower loss-absorbing capacity than Tier 1.
The CAR formula
– Basic formula:
CAR = (Tier 1 capital + Tier 2 capital) / Risk-weighted assets
Where Tier 1 capital usually includes CET1 plus AT1.
Step-by-step calculation checklist
1. Identify and total qualifying CET1 items (common shares, retained earnings, etc.).
2. Add qualifying AT1 instruments to get total Tier 1 capital.
3. Add qualifying Tier 2 capital (subordinated debt, certain reserves).
4. Calculate or obtain the bank’s RWA by applying regulatory risk weights to on‑ and off‑balance-sheet exposures and summing the results.
5. Apply the formula: (Tier1 + Tier2) ÷ RWA.
6. Express result as a percentage and compare to regulatory minima and internal targets.
Worked numeric example
– Inputs (example bank):
– Common equity and retained earnings (CET1): $18,000,000
– Additional Tier 1 instruments (AT1): $2,000,000
– Tier 2 capital (subordinated debt): $5,000,000
– Risk-weighted assets (RWA): $65,000,000
– Steps:
1. Total Tier 1 = CET1 + AT1 = $18,000,000 + $2,000,000 = $20,000,000
2. Total regulatory capital = Tier 1 + Tier 2 = $20,000,000 + $5,000,000 = $25,000,000
3. CAR = Total regulatory capital / RWA = $25,000,000 / $65,000,000 ≈ 0.3846
4. As a percentage: CAR ≈ 38.46%
– Interpretation: A CAR around 38% indicates a large capital buffer relative to risk‑weighted assets. Higher CAR generally means greater capacity to absorb losses; lower CAR signals less cushion and may trigger supervisory concern if it falls below regulatory minimums.
Why CAR matters
– Protects depositors and financial stability by ensuring banks hold capital that can absorb losses without immediate insolvency.
– Provides a standardized, risk-adjusted way for supervisors and market participants to compare banks’ loss-absorbing capacity.
– Influences a bank’s ability to lend and support economic activity—higher capital may constrain leverage but strengthens resilience.
CAR versus related measures
– Solvency ratio: A broader corporate finance metric that assesses a company’s ability to meet long-term obligations. CAR is a banking-specific, risk‑adjusted capital measure focused on credit and related risks.
– Tier‑1 leverage ratio: A non‑risk-based measure computed as Tier 1 capital divided by a bank’s average consolidated assets (unweighted). It complements CAR by limiting leverage irrespective of risk weights.
Limitations of CAR
– Risk weights are model- and rule-dependent; different approaches to weighting assets can materially change RWA and thus CAR.
– CAR focuses on credit risk weighting and doesn’t fully capture liquidity risk, interest-rate risk in the banking book, operational risk nuances, or market stress scenarios.
– Off‑balance-sheet exposures and complex instruments can be hard to quantify, producing measurement uncertainty.
– High CAR alone does not guarantee profitability or operational strength; it is one of several health indicators.
Basel framework — context
– The Basel Accords (Basel I/II/III) are international regulatory standards developed by the Basel Committee on Banking Supervision to set minimum capital and other prudential requirements for banks. Basel III increased minimum capital quality and added buffers after the 2008 crisis. National regulators implement Basel standards through local rules and supervisory practices.
Typical regulatory minima (overview)
– Under Basel III, regulators set minimums for CET1, Tier 1, and total capital, plus buffers (capital conservation buffer, countercyclical buffer, and systemically important bank buffers). Exact required percentages and how they’re applied can vary by jurisdiction and institution type. Check local regulator guidance for precise current thresholds.
Quick checklist for practitioners and students
– Verify definitions: Know what counts as CET1, AT1, and Tier 2 under applicable rules.
– Recompute RWA carefully: Check treatment of off‑balance-sheet items and guarantees.
– Compare to regulatory minima and internal targets: Include buffers for stress events.
– Supplement CAR with other metrics: leverage ratio, liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and stress test results.
– Note caveats: Understand model assumptions behind RWA and potential procyclicality.
Reputable sources for further reading
– Investopedia — Capital Adequacy Ratio (CAR)
https://www.investopedia.com/terms/c/capital
adequacyratio.asp
– Bank for International Settlements (BIS) — Basel III: A global regulatory framework https://www.bis.org/publ/bcbs189.pdf
– Basel Committee on Banking Supervision — Basel Framework (rules, standards, and monitoring) https://www.bis.org/basel_framework/
– U.S. Federal Reserve — Capital adequacy and supervisory guidance https://www.federalreserve.gov/supervisionreg/topics/capital.htm
– European Banking Authority (EBA) — CRR/CRD implementation and supervisory materials https://www.eba.europa.eu/regulation-and-policy
– International Monetary Fund (IMF) — Financial Soundness Indicators and banking sector guidance https://www.imf.org/external/np/sta/fsi/
Practical reminder: national and regional supervisors (central banks, prudential authorities) implement Basel standards differently and publish the legally binding rules and current numeric thresholds for CET1, AT1, Tier 2, countercyclical buffers, and systemic‑bank surcharges. Always consult the relevant supervisor’s website for the definitive requirements that apply to a given institution.
Educational disclaimer: This content is for educational purposes only and does not constitute investment, legal, or regulatory advice. It does not recommend specific actions or predict outcomes. Consult qualified professionals or your regulator for guidance tailored to your situation.