Capital Adequacy Ratio - Explained
What is a Capital Adequacy Ratio?
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Table of ContentsWhat is a Capital Adequacy Ratio?How Does a Capital Adequacy Ratio Work?Tier-1 capital Tier-2 capital Risk-Weighted Assets Capital Adequacy Ratio
What is a Capital Adequacy Ratio?
The capital adequacy ratio (CAR) is otherwise called Capital to Risk Assets Ratio (CRAR), it is the value of a banks capital as compared to its weighted risks. CAR seeks to assess the capital available to a bank and how this value influences its ability to pay liabilities and respond to credit exposures. Simply put, CAR indicates the ratio of a banks capital to its risk or credit exposures. CAR is important to regulators as it helps to determine the solvency of a bank or its ability to absorb losses given the available capital. CAR measures two types of capital which are tier-1 and tier-2 capital. The formula for calculating the capital adequacy ratio (CAR) is; Capital Adequacy Ratio Formula = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets
How Does a Capital Adequacy Ratio Work?
To calculate the capital adequacy ratio (CAR) of a bank, the capital of the bank will be divided by its risk-weighted otherwise known as risk-weighted exposures. Sine capital is categorized into two tiers; the two tiers are taken into consideration when calculating CAR.
This refers to the banks capital that grants it the ability to absorb losses and liabilities without the bank folding up. Examples of tier-1 capital include equity capital, intangible assets, ordinary share capital, and audited revenue reserves. This form of capital allows a bank attend to all liabilities without ceasing operations, it is also called the core capital.
Tier-2 capital allows a bank to pay liabilities and respond to credit risks even after it ceases operations, this capital provides an assurance to depositors that in the event of the bank folding-up, all liabilities will be paid. Examples of tier-2 capital are general loss reserves, unaudited retained earnings and unaudited reserves. The risk-weighted assets of a bank is determined by measuring its credit exposures and examining the risks of bank's loans. In calculating CAR, the tier-1 and tier-2 capitals are added up and divided by Risk-weighted assets.
Risk-weighted assets are used to measure the amount of capital that must be held by a bank based on the ratio of assets weighted by risk. This is to help banks avoid inability to pay liability or settle credit exposures. Risk-weighted assets help to determine the capital requirement needed to cater for the risk of each asset.
Capital Adequacy Ratio
Essentially, capital adequacy ratios (CARs) help banks determine the capital requirement that suits the percentage of risk in assets. Depositors are also assured of the solvency of a bank through CAR. CAR measures whether a bank's available capital is enough to settle the level of risks, liabilities and losses it may face. CARS ensure the financial health and stability of banks and help to guard against insolvency. A high CAR indicates that a bank is fit for operations and has the capacity to meet all financial needs or obligations. Such banks are able to absorb all losses in the event of winding-up. Here are the key points you should know about capital adequacy ratio (CAR);
- CAR measures the value or ratio of a banks capital as compared to its weighted risks.
- It is a ratio that determines whether banks have enough capital to absorb a level of risks or losses before winding-up.
- National regulators and policymakers monitor CARs to determine how financially adequate the banks are.
- The capital adequacy ratio measures two types of capital, they are; Tier-1 capital and Tier-2 capital.
- Tier-1 capital is the core capital which means a bank can absorb a level of losses without winding-up business.
- Tier-2 capital indicates that even after winding-up, a bank can still absorb losses.