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Capital Adequacy Ratio is a critical measure used to assess the financial health of banks. It indicates the proportion of a bank’s capital to its risk-weighted assets and ensures that the institution can absorb a reasonable amount of loss while meeting obligations. By setting minimum CAR requirements, regulators safeguard depositors and maintain stability in the financial system.
Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk-weighted assets. It is expressed as a percentage and reflects the bank’s ability to withstand financial stress.
A higher CAR indicates that the bank has sufficient capital to cover potential losses, while a lower ratio suggests vulnerability in times of economic downturns. Regulatory bodies such as the Reserve Bank of India (RBI) and the Basel Committee on Banking Supervision set minimum CAR requirements to ensure global financial stability.
The importance of CAR can be understood by its role in promoting financial discipline.
Protects depositors by ensuring banks maintain adequate buffers against losses
Reduces the risk of bank failures that could destabilise the economy
Encourages prudent lending practices by linking capital requirements to risk levels
The CAR is calculated using two main types of capital, classified under Basel norms.
| Component | Description | Example |
|---|---|---|
Tier 1 Capital |
Core capital including equity capital and disclosed reserves |
Paid-up share capital, retained earnings |
Tier 2 Capital |
Supplementary capital that acts as a buffer |
Subordinated debt, hybrid instruments, revaluation reserves |
Together, both tiers form the numerator in the CAR formula, ensuring banks have strong core capital and additional buffers to manage risk.
The standard formula to calculate CAR is:
CAR = (Tier 1 Capital + Tier 2 Capital) ÷ Risk-Weighted Assets × 100
Here,
Tier 1 Capital: Core equity capital
Tier 2 Capital: Supplementary reserves
Risk-Weighted Assets (RWA): Assets weighted according to credit, market, and operational risks
This formula measures capital relative to the bank’s level of risk.
Suppose a bank has the following details:
Tier 1 Capital = ₹1,000 Crores
Tier 2 Capital = ₹500 Crores
Risk-Weighted Assets = ₹10,000 Crores
Applying the formula:
CAR = (₹1,000 + ₹500) ÷ ₹10,000 × 100
CAR = 15%
This means the bank’s capital is equal to 15% of its risk-weighted assets, which is well above the minimum requirement of 9% set by the RBI for Indian banks.
Capital Adequacy Ratio provides several key benefits for the banking system.
Builds depositor and investor confidence in the bank’s stability
Encourages banks to manage risks responsibly
Acts as an early warning system for potential financial distress
Despite its usefulness, CAR has certain limitations.
Focuses on quantitative buffers but does not fully account for qualitative factors like governance
Different countries may have varying minimum CAR requirements, reducing comparability
Overemphasis on capital buffers may discourage lending in times of economic slowdown
Assumes risk weights are accurate, which may not always capture real-world complexities
In India, the Reserve Bank of India mandates that banks maintain a minimum CAR of 9%, which is higher than the Basel Committee’s global requirement of 8%. This stricter norm ensures that Indian banks are more resilient to financial shocks.
For example, during periods of economic uncertainty, Indian banks with stronger CARs were able to continue lending and maintain stability, while global peers with weaker ratios faced difficulties.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
The Capital Adequacy Ratio is a fundamental tool in banking regulation, designed to ensure financial institutions maintain sufficient capital to absorb risks. While it strengthens the stability of banks and protects depositors, it should be evaluated along with other indicators of financial health for a complete analysis.
Capital ratio, or Capital Adequacy Ratio, is calculated by dividing a bank’s total capital (Tier 1 + Tier 2) by its risk-weighted assets and multiplying by 100.
There is no difference between CRAR and CAR; both terms are used interchangeably to describe the ratio of a bank’s capital to its risk-weighted assets.
The capital adequacy ratio is the percentage of a bank’s capital relative to its risk-weighted assets, indicating its ability to withstand potential losses and protect depositors.
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