The capital adequacy ratio is computed by dividing the total capital of a bank by its risk-weighted assets. This is why the CAR is also called the Capital to Risk (Weighted) Assets Ratio (CRAR).
The capital adequacy ratio formula for banks in India is given below.
Capital adequacy ratio = (Tier 1 capital + Tier 2 capital + Tier 3 capital) ÷ Risk-weighted assets
Let us understand how the capital adequacy ratio formula works with the help of a hypothetical example. Consider the following details for a banking company.
Tier 1 capital: Rs. 10,00,000
Tier 2 capital: Rs. 5,00,000
Tier 3 capital: Rs. 2,00,000
Leased assets: Rs. 15,00,000 (Risk weight of 100%)
Loans to PSUs: Rs. 40,00,000 (Risk weight of 100%)
Advances covered by DICGC: 6,00,000 (Risk weight of 50%)
Based on the above information, the total capital of the bank is:
= (Tier 1 capital + Tier 2 capital + Tier 3 capital)
= Rs. (10,00,000 + 5,00,000 + 2,00,000)
= Rs. 17,00,000
Also, the total risk-weighted assets of the bank are:
= (100% of Rs. 15,00,000 + 100% of Rs. 40,00,000 + 50% of Rs. 6,00,000)
= Rs. 15,00,000 + Rs. 40,00,000 + Rs. 3,00,000
= Rs. 58,00,000
So, the capital adequacy ratio is:
= (Tier 1 capital + Tier 2 capital + Tier 3 capital) ÷ Risk-weighted assets
= Rs. 17,00,000 ÷ Rs. 58,00,000
= 29.31%
What Does the CAR (CRAR) Formula Tell Us?
You have now seen the capital adequacy ratio formula and computation. But what do the different types of capital mean? Let us decode the formula.
1. Tier 1 capital
This capital forms the primary protective capital of the bank. It includes stable and liquid items like the paid-up capital, statutory reserves, retained earnings and other free reserves disclosed in the balance sheet.
2. Tier 2 capital
This includes the secondary or supplementary capital of a bank. Examples of such capital include undisclosed reserves, cumulative preference shares, revaluation reserves, subordinated debt, and loss reserves.
3. Tier 3 capital
Tier 3 capital is generally used to cover market-related risks. It may be held in the form of short-term subordinated debts. However, such capital should be capable of being converted into permanent capital.
4. Risk-weighted assets
Banks hold different types of assets, each with varying degrees of risk. These assets are adjusted according to the risk that they carry using an appropriate weightage factor set by the RBI.
Why is Capital Adequacy Ratio important?
Depositors' money is only at risk if the bank suffers losses bigger than the money it has set aside (its capital). So, the higher a bank's capital adequacy ratio, the safer your savings are.
1. Financial stability and confidence
CRAR helps maintain the stability and integrity of the banking system in India by ensuring that banks can withstand financial shocks. This instills confidence among depositors, investors, and other stakeholders, which is crucial for the overall health of the financial system. A stable banking system is fundamental to sustaining economic growth.
2. Regulatory compliance
The Reserve Bank of India (RBI) mandates specific CAR requirements to ensure banks are adequately capitalised. This is aligned with the Basel III norms, which are international regulatory frameworks designed to improve the regulation, supervision, and risk management within the banking sector. Indian banks must adhere to these norms to operate effectively both domestically and internationally.
3. Risk management
India's economy is diverse and dynamic, with significant exposure to various sectors, including agriculture, small and medium enterprises (SMEs), and infrastructure. A robust CAR ensures that banks have a sufficient buffer to manage risks associated with non-performing assets (NPAs) and sectoral downturns. This is particularly pertinent in India, where NPAs have been a significant concern.
4. Credit growth
A healthy CAR allows banks to expand their lending activities. With adequate capital, banks can extend more credit to businesses and consumers, fueling economic activity. This is crucial for India's growth trajectory, where access to credit is vital for sectors like manufacturing, services, and agriculture.
5. Investor and market trust
For banks listed on the stock market, a strong CRAR is a positive signal to investors and analysts, reflecting prudent management and a lower risk profile. This can lead to better stock performance and easier access to capital markets for raising funds.
CAR vs the Solvency ratio
Let us explore the key differences between CAR and the Solvency ratio:
Basis
|
Capital Adequacy Ratio (CAR)
|
Solvency Ratio
|
Definition
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Measures a bank’s capital in relation to its risk-weighted assets
|
Measures a company’s ability to meet long-term debts
|
Applicability
|
Mainly for banks and financial institutions
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Applicable to all companies and industries
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Formula
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(Tier 1 Capital + Tier 2 Capital) / Risk-weighted Assets × 100
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(Net Profit + Depreciation) / Total Liabilities × 100
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Regulated by
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RBI, Basel III norms
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No fixed regulator; mainly used in company financial analysis
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Main Purpose
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Ensure stability and risk resilience in the banking sector
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Evaluate a company’s long-term financial health
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Interpretation
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Higher ratio indicates a safer and more stable bank for depositors
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Higher ratio signals lower risk of insolvency for the company
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Limitations of the capital adequacy ratio
Let us explore the disadvantages of the CRAR ratio:
1. Overlooking expected losses
CAR does not account for expected and identifiable losses during financial crises. This oversight can lead to an overestimation of a bank’s financial strength in times of economic stress.
2. Static risk weightings
CAR uses fixed risk weightings for asset classes, which may not accurately reflect their true risk over time. This static approach can misrepresent a bank’s risk exposure, especially during economic volatility.
3. Regulatory compliance focus
Banks may focus on meeting CRAR requirements rather than managing actual risks. This compliance-driven approach can lead to regulatory arbitrage, where banks structure assets to fit regulatory definitions instead of mitigating real risks.
4. Ignoring market and liquidity risks
CAR primarily addresses credit risk, overlooking market and liquidity risks. These risks can significantly impact a bank’s financial health, especially in volatile market conditions or liquidity shortages, but are not fully captured by CAR.
Conclusion
- This sums up the definition of the capital adequacy ratio, the capital adequacy ratio formula and why the CAR is important. In addition to being an indicator used by regulators to assess bank solvency, the capital adequacy ratio is also useful for investors eager to diversify into the banking sector. Before you take a long position in any banking stock, ensure that the company has adequate capital to cover its losses.
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