Capital Adequacy Ratio – Definition

Cite this article as:"Capital Adequacy Ratio – Definition," in The Business Professor, updated September 20, 2019, last accessed August 11, 2020, https://thebusinessprofessor.com/lesson/capital-adequacy-ratio-definition/.

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Capital Adequacy Ratio Definition

The capital adequacy ratio (CAR) is otherwise called Capital to Risk Assets Ratio (CRAR), it is the value of a bank’s 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 bank’s 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

A Little More on What is the Capital Adequacy Ratio

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.

Tier-1 capital

This refers to the bank’s 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

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

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 bank’s 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.

Reference for “ Capital Adequacy Ratio”

https://en.wikipedia.org/wiki/Capital_adequacy_ratio

https://www.investopedia.com/terms/c/capitaladequacyratio.asp

www.sbp.org.pk/bsrvd/pdf/…/Draft%20Basel%203%20Guidelines%20(BPC).pdf

https://en.wikipedia.org/wiki/Capital_adequacy_ratio

https://marketbusinessnews.com/financial-glossary/capital-adequacy-ratio-car/

Academic research on “Capital adequacy ratio –CAR”

The relationship between risk and capital in commercial banks, Shrieves, R. E., & Dahl, D. (1992). The relationship between risk and capital in commercial banks. Journal of Banking & Finance16(2), 439-457. This study investigates the relationship between changes in risk and capital in a large sample of banks. A positive association between changes in risk and capital is found. The fact that this finding holds in banks with capital ratios in excess of regulatory minimum levels supports the conclusion that, for most banks, bank owners’ and/or managers’ private incentives work to limit total risk exposure. Results for banks which were undercapitalized by regulatory standards indicate that regulation was at least partially effective during the period covered. Overall, the findings support a conclusion that changes in bank capital over the period studied have been ‘risk-based’.

Impacts of capital adequacy regulation on risk-taking behaviors of banking Zhang, Z. Y., Jun, W. U., & Liu, Q. F. (2008). Impacts of capital adequacy regulation on risk-taking behaviors of banking. Systems Engineering-Theory & Practice28(8), 183-189. Based on the dynamic nature of banks’ continuous operation, this article examines the effects of capital adequacy requirement on bank’s risk-taking behaviors, and furthermore empirically investigates the impacts on Chinese commercial banks from the implementation of the capital standard, Regulation Governing Capital Adequacy of Commercial Banks. The theoretical model concludes that the optimal ratio of risk assets decreases while the capital ratio increases, and an increase in capital-to-asset ratio would reduce the risk-taking behavior. Meanwhile, the empirical evidences suggest that changes in capital is negatively associated with the changes in risk in a significant way, thus implying that increasing capital ratio would be effective in reducing portfolio risk with the implementation of Regulation Governing Capital Adequacy of Commercial Banks.

Risk-based capital, portfolio risk, and bank capital: A simultaneous equations approach Jacques, K., & Nigro, P. (1997). Risk-based capital, portfolio risk, and bank capital: A simultaneous equations approach. Journal of Economics and business49(6), 533-547. This paper examines the impact the risk-based capital standards had on bank capital and portfolio risk during the first year the risk-based standards were in effect. To date, insufficient attention has been focused on how the risk-based capital standards have impacted bank capital and risk. Building on previous research, this study used a three-stage least squares (3SLS) model to analyze the relationship between bank capital, portfolio risk, and the risk-based capital standards. The results suggest that the risk-based capital standards were effective in increasing capital ratios and reducing portfolio risk in commercial banks.

The impact of the 1988 Basel Accord on banks’ capital ratios and credit risk-taking: an international study Van Roy, P. (2005, July). The impact of the 1988 Basel Accord on banks’ capital ratios and credit risk-taking: an international study. In EFMA 2004 Basel Meetings, Forthcoming. One of the requirements of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was that bank regulators establish capital ratio zones that mandate prompt corrective action (PCA) and early intervention in troubled banks. However, prior research suggests that increases in regulatory capital standards can lead to offsetting increases in risk. This paper develops and estimates a 3SLS model to examine the simultaneous impact of PCA on both bank capital and credit risk. The results document that the FDICIA was effective in that, subsequent to its passage, US banks increased their capital ratios without offsetting increases in credit risk.

Capital adequacy, management and performance in the Nigerian commercial bank (1986-2006) Ikpefan, O. A. (2013). Capital adequacy, management and performance in the Nigerian commercial bank (1986-2006). African Journal of Business Management7(30), 2938-2950. This study investigates the impact of bank capital adequacy ratios, management and performance in the Nigerian commercial bank (1986 – 2006). The objectives of this paper are: to determine to what extent bank capital adequacy ratios impact on bank performance and also to investigate the extent to which operation expenses has impacted on the return on capital. The study captured their performance indicators and employed cross sectional and time series of bank data obtained from Central Bank of Nigeria (CBN) and Annual Report and Financial statements of the sampled banks. The formulated models were estimated using ordinary least square regression method. The overall capital adequacy ratios of the study shows that Shareholders Fund/Total Assets (SHF/TA) which measures capital adequacy of banks (risk of default) have negative impact on ROA. The efficiency of management measured by operating expenses indice is negatively related to return on capital. The implication of this study, among others, is that adequate shareholders fund can serve as a veritable stimulant in strengthening the performance of Nigerian commercial banks and also heighten the confidence of customers especially in this era of global economic meltdown that has taken its toll in the Nigerian financial system.

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