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What is Capital Adequacy Ratio (CAR)?
The Capital Adequacy Ratio (CAR) measures a bank’s ability to absorb losses by comparing its capital to its risk‑weighted assets. It ensures banks remain financially stable and capable of meeting obligations.
Definition
The Capital Adequacy Ratio (CAR) is a regulatory metric that expresses a bank’s capital as a percentage of its risk‑weighted assets, ensuring it has enough cushion to withstand financial stress.
Key Takeaways
- Required by global banking regulations (e.g., Basel III).
- Protects depositors and maintains financial system stability.
- Compares bank capital to risk‑weighted assets.
- Higher CAR = stronger financial resilience.
Understanding Capital Adequacy Ratio (CAR)
CAR is a regulatory safeguard that ensures banks maintain sufficient capital to absorb potential losses. Capital is divided into two tiers:
- Tier 1 Capital: Core equity capital and disclosed reserves.
- Tier 2 Capital: Supplementary capital such as subordinated debt.
Risk‑weighted assets (RWA) adjust asset values based on their riskiness—government bonds have low risk weights, while unsecured loans have higher weights.
Regulatory bodies such as the Basel Committee require minimum CAR levels to protect financial systems from bank failures and credit crises.
Formula
CAR = (Tier 1 Capital + Tier 2 Capital) / Risk‑Weighted Assets × 100
Real-World Example
If a bank has:
- Tier 1 Capital: $10 billion
- Tier 2 Capital: $3 billion
- Risk‑Weighted Assets: $100 billion
CAR = (10 + 3) / 100 × 100 = 13%
This exceeds many regulatory minimums (often around 10–12%), indicating strong capital health.
Importance in Business or Economics
- Prevents bank insolvency.
- Strengthens public confidence.
- Ensures stability in financial markets.
- Helps regulators monitor systemic risk.
Types or Variations
- Tier 1 Capital Ratio
- Tier 2 Capital Ratio
- Common Equity Tier 1 (CET1) Ratio
- Total Capital Ratio
Related Terms
- Basel III
- Risk‑Weighted Assets (RWA)
- Bank Capital Structure
- Solvency Ratio
Sources and Further Reading
- Bank for International Settlements – Basel Framework
- IMF – Financial Stability Indicators
- Investopedia – Capital Adequacy Ratio
Quick Reference
- Healthy Range: Above regulatory minimum.
- Risk Weighting: Adjusts for asset riskiness.
- Purpose: Ensures bank solvency.
Frequently Asked Questions (FAQs)
Why is CAR important?
It ensures banks can absorb losses and protect depositors.
Who sets CAR requirements?
Global standards come from the Basel Committee; local regulators set national minimums.
Can a bank operate with low CAR?
Only temporarily—persistent low CAR triggers regulatory intervention.
