Basics of Capital Adequacy Ratio (CAR)

What is Capital Adequacy Ratio
It is the measure of a banks financial strength expressed by the ratio of its capital (net worth and subordinated debt) to its risk-weighted credit exposure (loans).It is also called CRAR-Capital to Risk-weighted Assets Ratio.The Reserve Bank of India (RBI),currently prescribes a minimum capital of 9% of risk-weighted assets,which is higher than the internationally prescribed percentage of 8%.Most banks in India have a capital adequacy of more than 12 %.A bank with a higher capital adequacy is considered safer because if its loans go bad,it can make up for it from its net worth.
What does Tier-I capital mean
Tier-I capital is also referred to as core capital.This includes equity capital and disclosed reserves.This component of a banks capital essentially serves the purpose of absorbing losses without a bank requiring to cease trading.Tier-II capital,secondary capital of a bank,consists of undisclosed reserves,general loss reserves,subordinate term debts which can absorb losses in the event of a winding-up,and thus providing a lesser degree of protection to depositors.
Why do banks have to maintain CAR
CAR is the ratio that measures a banks capacity to meet time liabilities and risks likeoperational risks,credit risks and other risks.Indias bank regulator,RBI,has prescribed a minimum ratio to be maintained by the banking system.This is done because the depositors are secured about their deposits and banks have a cushion for their potential losses.In the face of the financial crises seen in the last few years,maintenance of CAR is mandated by the regulatory authorities to protect the depositors.
What is risk weighting
Every financial asset carries a risk.The extent of risk,however,varies.For instance,government bonds carry almost no risk while loans to government-promoted companies carry some risk.On the other hand,loans to a corporate carry 100% risk weighted as the entire loan is exposed to risk.Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such asset.
How are risk weight assigned
Different types of assets have different profiles in risk value.CAR primarily adjusts for assets that are less risky by allowing banks to discount lower-risk assets.The specifics of CAR calculation vary from country to country.In the most basic application,government debt is allowed a 0% risk weighting that is,they are subtracted from total assets for purposes of calculating the CAR