Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR)

[1]
, is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it
can absorb a reasonable amount of loss [2] and are complying with their statutory Capital
requirements.

Contents
[hide]

• 1 Formula
• 2 Use
• 3 Risk weighting
○ 3.1 Risk weighting example
• 4 Types of capital
• 5 See also
• 6 References
• 7 External links

[edit] Formula
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Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a
percentage of its risk weighted credit exposures.
Capital adequacy ratio is defined as
where Risk can either be weighted assets () or the respective national regulator's minimum total
capital requirement. If using risk weighted assets,
≥ 10%.[1]
The percent threshold (10% in this case, a common requirement for regulators conforming to the
Basel Accords) is set by the national banking regulator.
Two types of capital are measured: tier one capital (T1 above), which can absorb losses without a
bank being required to cease trading, and tier two capital (T2 above), which can absorb losses in
the event of a winding-up and so provides a lesser degree of protection to depositors.
[edit] Use
Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting
the time liabilities and other risk such as credit risk, operational risk, etc. In the most simple
formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's
depositors or other lenders. Banking regulators in most countries define and monitor CAR to
protect depositors, thereby maintaining confidence in the banking system.[1]
CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-
to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity;
since assets are by definition equal to debt plus equity, a transformation is required). Unlike
traditional leverage, however, CAR recognizes that assets can have different levels of risk.
[edit] Risk weighting
Since different types of assets have different risk profiles, 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, but general approaches tend to be similar for countries
that apply the Basel Accords. 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.
[edit] Risk weighting example
Local regulations establish that cash and government bonds have a 0% risk weighting, and
residential mortgage loans have a 50% risk weighting. All other types of assets (loans to
customers) have a 100% risk weighting.
Bank "A" has assets totaling 100 units, consisting of:
• Cash: 10 units.
• Government bonds: 15 units.
• Mortgage loans: 20 units.
• Other loans: 50 units.
• Other assets: 5 units.
Bank "A" has deposits of 95 units, all of which are deposits. By definition, equity is equal to
assets minus debt, or 5 units.
Bank A's risk-weighted assets are calculated as follows:

Cash 10 * 0% = 0

Government
15 * 0% = 0
bonds

20 * 50% =
Mortgage loans
10

50 * 100%
Other loans
= 50
 5 * 100% =
Other assets
5

Total risk

Weighted
65
assets

Equity 5

CAR
7.69%
(Equity/RWA)

Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equity-to-assets of
only 5%, its CAR is substantially higher. It is considered less risky because some of its assets are
less risky than others.
[edit] Types of capital
The Basel rules recognize that different types of equity are more important than others. To
recognize this, different adjustments are made:
1. Tier I Capital: Actual contributed equity plus retained earnings.
2. Tier II Capital: Preferred shares plus 50% of xxxxxsubordinated debt.
Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets may
be 4%, while minimum CAR including Tier II capital may be 8%.
There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending
on the jurisdiction.

Tier 1 capital
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Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.
It is composed of core capital,[1] which consists primarily of common stock and disclosed
reserves (or retained earnings)[2], but may also include non-redeemable non-cumulative preferred
stock.
Capital in this sense is related to, but different from, the accounting concept of shareholders'
equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained
substantially the same in the replacement Basel II accord.
Each country's banking regulator, however, has some discretion over how differing financial
instruments may count in a capital calculation. This is appropriate, as the legal framework varies
in different legal systems.
The theoretical reason for holding capital is that it should provide protection against unexpected
losses. Note that this is not the same as expected losses which are covered by provisions,
reserves and current year profits.
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total assets. The Tier 1
risk based capital ratio is the ratio of a bank's core (equity capital) to its total risk-weighted
assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for
credit risk according to a formula determined by the Regulator (usually the country's Central
bank). Most central banks follow the Bank for International Settlements (BIS) guidelines in
setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight,
while debentures might have a risk weight of 100%.
A good definition of Tier 1 capital is that it includes equity capital and disclosed reserves, where
equity capital includes instruments that can't be redeemed at the option of the holder (meaning
that the owner of the shares cannot decide on his own that he wants to withdraw the money he
invested and so cannot leave the bank without the risk coverage). Reserves are held by the bank,
and are thus money that no one but the bank can have an influence on.
Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses.
Tier 2
Capital is a measure of a bank's financial strength with regard to the second most reliable form of
financial capital, from a regulator's point of view. The forms of banking capital were largely
standardised in the Basel I accord, issued by the Basel Committee on Banking Supervision and
left untouched by the Basel II accord. National regulators of most countries around the world
have implemented these standards in local legislation.
Tier 1 capital is considered the more reliable form of capital.
There are several classifications of tier 2 capital. In the Basel I Accord, tier 2 capital is composed
of supplementary capital, which is categorised as undisclosed reserves, revaluation reserves,
general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be
considered tier 2 capital up to an amount equal to that of the core capital.[1]
_____________________________________________________________________________
___________________

Undisclosed Reserves
Undisclosed reserves are not common, but are accepted by some regulators where a bank has
made a profit but this has not appeared in normal retained profits or in general reserves of the
bank.
[edit] Revaluation Reserves
A revaluation reserve is a reserve created when a company has an asset revalued and an increase
in value is brought to account. A simple example may be where a bank owns the land and
building of its head-offices and bought them for $100 a century ago. A current revaluation is
very likely to show a large increase in value. The increase would be added to a revaluation
reserve.
[edit] General Provisions
A general provision is created when a company is aware that a loss may have occurred but is not
sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions
were commonly created to provide for losses that were expected in the future. As these did not
represent incurred losses, regulators tended to allow them to be counted as capital.
[edit] Hybrid Instruments
Hybrids are instruments that have some characteristics of both debt and shareholders' equity.
Provided these are close to equity in nature, in that they are able to take losses on the face value
without triggering a liquidation of the bank, they may be counted as capital. Preferred stocks are
hybrid instruments.
[edit] Subordinated Term Debt
Subordinated debt is debt that ranks lower than ordinary depositors of the bank.