Among the many tools that help one measure the financial stability of an entity is its capital adequacy ratio.
What is capital adequacy ratio?
Capital adequacy ratio (CAR) is the ratio of a bank’s available capital in relation to the risks involved in terms of loan disbursement. In other words, capital adequacy ratio is the ratio of a bank’s capital in relation to its assets and liabilities. A credit solvency maintenance tool used by banking authorities to help banks stay fiscally fit, capital adequacy ratio is also known as capital-to-risk weighted asset ratio (CRAR).
Banking regulators often ask banks to keep and maintain a certain percentage of their debt exposure as its assets. Known as the bank’s capital adequacy ratio, this rate is expressed in terms of percentage. In simple terms, capital adequacy ratio measures how much capital a bank has, as a percentage of its total debt exposure.
Purpose of capital adequacy ratio
National banking regulators like the Reserve Bank of India (RBI) and international banking norms like BASEL, provide for capital adequacy ratios for banks in order to prevent them from over-leveraging and becoming debt-laden in the process, without having enough liquidity that could act as a cushion in case of any monetary strain.
This way, banking regulators enforce financial discipline among banks and maintain the overall health of the banking system, thereby, safeguarding the investment of the depositor.
Maintaining the capital-to-risk weighted asset ratio makes banks more resilient in the event of financial turmoil such as the one witnessed during the global financial crisis of 2008 or the more local non-banking finance crisis of 2019.
See also: What is debt-to-income (DTI) ratio?
Formula to measure capital adequacy ratio
The formula used calculate capital adequacy ratio is:
(Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets)
While measuring a bank’s capital adequacy ratio, there are three types of capital that are taken into account:
Tier-I capital: This is the asset lying with the bank that can help it to absorb any shock without winding up its operations. Tier-I capital is a bank’s core capital including the shareholders’ equity and retained earnings.
Tier-II capital: This is the asset lying with the bank that can absorb losses in the event of it seeing closure. A bank’s Tier-II capital is made of revaluation reserves, hybrid capital instruments and subordinated term debt.
Tier-III capital: This is a mix of Tier-II capital and the short-term subordinated loans.
What is Basel-III?
An international regulatory standard, Basel-III establishes norms to supervise the banking sector.
See also: All about Indian accounting standards (Ind AS)
Capital adequacy ratio in 2023
Under Basel-III, banks have to maintain a minimum capital adequacy ratio of 8%. However, scheduled commercial banks in India are required to maintain a CAR of 9% and public sector banks are directed to maintain a CAR of 12% according to the RBI guidelines.
While a lower capital adequacy rate will allow banks to lend more, it would also expose them to higher risks. Conversely, while a high capital adequacy rate will curb a bank’s capacity to lend, it will help them maintain fiscal health.
News update
Banks should have adequate capital buffers, liquidity: RBI governor
April 28, 2023: Reserve Bank of India (RBI) governor Shaktikanta Das has said that macro stress tests conducted for ascertaining the credit risk on the loan books of banks’ show that lenders would stay compliant with minimum capital regulatory norms even in the case of extreme stress. The RBI mandates banks to maintain a minimum capital adequacy ratio of at least 9% or above.
“The Reserve Bank has, therefore, started looking at the business models of banks more closely. Aspects or deficiencies in the business model itself can spark a crisis in due course. We have not only prescribed regulatory norms for capital adequacy and liquidity ratios, but even gone beyond to nudge banks to build up capital buffers in good times and times of plenty,” he said at a global conference on financial resilience.
FAQs
When was the first Basel accord signed?
The first Basel accord, Basel I, was published in 1988.
When was the second Basel accord signed?
The second Basel accord, Basel II, was published in 2004.
When were the Basel-III leverage requirements set out?
The Basel-III leverage requirements were set out in several phases, starting 2013.