Capital Adequacy Ratio

The capital adequacy ratio (CAR) indicates how much capital a bank has available to absorb losses relative to the risks it carries. Also called the capital to risk-weighted assets ratio (CRAR), it measures regulatory capital as a percentage of risk-weighted assets. A higher ratio generally indicates a larger loss-absorbing cushion, provided risks are measured adequately and the capital is of comparable quality.

How the ratio is calculated

The formula is: CAR = (Eligible regulatory capital / Risk-weighted assets) × 100. Unlike a simple capital-to-total-assets ratio, it adjusts the denominator for the risks associated with a bank’s activities.

• Regulatory capital consists of eligible capital instruments and reserves, after prescribed regulatory adjustments; it is not the bank’s deposits or a separate stock of cash.
• Risk-weighted assets (RWA) reflect credit, market and operational risks under the applicable regulatory framework.
• An exposure carrying a higher risk weight requires more capital than an equal-sized exposure carrying a lower risk weight.

What it reveals about loss-absorbing capacity

Capital provides a buffer against unexpected losses. When losses reduce the value of a bank’s assets, capital can absorb them before depositors and other creditors bear losses.

• Other things being equal, a higher CAR means that the bank can absorb greater losses relative to its measured risks before breaching its regulatory capital requirement.
• Tier 1 capital, especially common equity, supports loss absorption while the bank continues operating.
• Tier 2 capital primarily supports loss absorption when the bank is no longer viable, so two banks with the same CAR need not have equally strong capital positions.
• Adequate capital supports depositor confidence and financial stability, while constraining the expansion of risky exposures without sufficient capital backing.

What the ratio cannot establish

CAR is an indicator of capital strength, not a complete certificate of safety. Its usefulness depends on accurate asset valuation, recognition of losses and measurement of risk.

• A high CAR does not establish liquidity: a bank may have adequate capital yet struggle to meet immediate withdrawals or payment obligations.
• Reported capital strength can be overstated if bad loans or losses are not recognised adequately.
• Assessment should therefore also consider asset quality, provisioning, profitability, liquidity and concentrations of lending.