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Capital Adequacy Ratio (CAR) - Overview and Example

The Capital Adequacy Ratio (CAR) measures a bank's ability to absorb losses by comparing its capital to risk-weighted assets. The CAR formula divides a bank's Tier 1 and Tier 2 capital by its risk-weighted assets. Capital requirements set by the Bank of International Settlements have become stricter in recent years to protect depositors.

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106 views7 pages

Capital Adequacy Ratio (CAR) - Overview and Example

The Capital Adequacy Ratio (CAR) measures a bank's ability to absorb losses by comparing its capital to risk-weighted assets. The CAR formula divides a bank's Tier 1 and Tier 2 capital by its risk-weighted assets. Capital requirements set by the Bank of International Settlements have become stricter in recent years to protect depositors.

Uploaded by

Olmedo Farfan
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Home › Resources › Knowledge › Finance › Capital Adequacy

Ratio (CAR)

Capital Adequacy Ratio (CAR)


Measures the ability of the bank to absorb losses

Written by CFI Team


Updated June 21, 2022

What is the Capital Adequacy Ratio (CAR)?


The Capital Adequacy Ratio set standards for banks by looking at a
bank’s ability to pay liabilities, and respond to credit risks and
operational risks. A bank that has a good CAR has enough capital to
absorb potential losses. Thus, it has less risk of becoming insolvent and
losing depositors’ money. After the financial crisis in 2008, the Bank of
International Settlements (BIS) began setting stricter CAR requirements
to protect depositors.
Summary
The Capital Adequacy Ratio (CAR) helps make sure banks have
enough capital to protect depositors’ money.

The formula for CAR is: (Tier 1 Capital + Tier 2 Capital) / Risk-
Weighted Assets

Capital requirements set by the BIS have become more strict


in recent years.

What is the Capital Adequacy Ratio Formula?


As shown below, the CAR formula is:
CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

The Bank of International Settlements separates capital into Tier 1 and


Tier 2 based on the function and quality of the capital. Tier 1 capital is
the primary way to measure a bank’s financial health. It includes
shareholder’s equity and retained earnings, which are disclosed on
financial statements.

As it is the core capital held in reserves, Tier 1 capital is capable of


absorbing losses without impacting business operations. On the other
hand, Tier 2 capital includes revalued reserves, undisclosed reserves,
and hybrid securities. Since this type of capital has lower quality, is less
liquid, and is more difficult to measure, it is known as supplementary
capital.

The bottom half of the equation is risk-weighted assets. Risk-weighted


assets are the sum of a bank’s assets, weighted by risk. Banks usually
have different classes of assets, such as cash, debentures, and bonds,
and each class of asset is associated with a different level of risk. Risk
weighting is decided based on the likelihood of an asset to decrease in
value.

Asset classes that are safe, such as government debt, have a risk
weighting close to 0%. Other assets backed by little or no collateral, such
as a debenture, have a higher risk weighting. This is because there is a
higher likelihood the bank may not be able to collect the loan. Different
risk weighting can also be applied to the same asset class. For example, if
a bank has lent money to three different companies, the loans can have
different risk weighting based on the ability of each company to pay back
its loan.

Calculating the Capital Adequacy Ratio (CAR) – Worked


Example
Let us look at an example of Bank A. Below is the information of Bank A’s
Tier 1 and 2 Capital, and the risks associated with their assets.

Bank A has three types of assets: Debenture, Mortgage, and Loan to the
Government. To calculate the risk-weighted assets, the first step is to
multiply the amount of each asset by the corresponding risk weighting:

Debenture: $9,000 * 90% = $8,100

Mortgage:  $45,000 * 75% = $33,750

Loan to Government: $4,000 * 0% = $0

As the loan to the government carries no risk, it contributes $0 to the


risk-weighted assets.

The second step is to add the risk-weighted assets to arrive at the total:

Risk-Weighted Assets: $8,100 + $33,750 + $0 = $41,850

The calculation can be easily done on Excel using the SUMPRODUCT


function.

To learn more about Excel functions, take a look at CFI’s free Excel
course.
The Capital Adequacy Ratio of Bank A is as follows :

Where:

CAR : $4,000 / $41,850 = 10%

As Bank A has a CAR of 10%, it has enough capital to cushion potential


losses and protect depositors’ money.

What are the Requirements?


Under Basel III, all banks are required to have a Capital Adequacy Ratio
of at least 8%. Since Tier 1 Capital is more important, banks are also
required to have a minimum amount of this type of capital. Under Basel
III, Tier 1 Capital divided by Risk-Weighted Assets needs to be at least 6%.

Additional Resources
Thank you for reading CFI’s guide to Capital Adequacy Ratio. To keep
learning and advancing your career, the following CFI resources will be
helpful:

Bank Run 

Financial Statement for Banks

Financial Intermediary 
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