What is the Capital Adequacy Ratio (CAR)

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Key Takeaways

• CAR shows a bank’s ability to absorb losses and protect depositors.
• It is calculated using Tier 1 and Tier 2 capital against risk-weighted assets.
• RBI mandates a minimum CAR of 9% for banks and 12% for public sector banks.
• The Basel Accords provide global standards for capital adequacy and risk control.
• While essential, CAR has limitations as it overlooks liquidity and asset quality risks.

What is the Capital Adequacy Ratio (CAR)

The Capital Adequacy Ratio (CAR), also known as the CRAR ratio, is used by central banks, regulators, investors, and credit rating agencies to assess the financial strength and stability of banks. By setting minimum capital requirements, banks are ensured to remain strong enough to absorb potential losses and protect depositors, thereby supporting a stable and secure banking system.

Importance of Capital Adequacy Ratio in Banking

The Capital Adequacy Ratio is essential for the safety, stability, and trustworthiness of banks. It acts as a financial buffer to protect deposits, maintain confidence in the banking sector. Several important aspects of the Capital Adequacy Ratio (CAR) include:

Serves as a Cushion of Safety:

The CAR in banking represents the capital set aside to absorb potential losses from bad loans, risky investments, or other shocks. The higher the CAR, the lower the risk of bank failure.

Protects Depositors:

Sufficient capital translates into safer customer deposits. Banks with high CARs can absorb losses without plunging into insolvency.

Ensures Compliance with Regulations:

Regulators like the Reserve Bank of India (RBI) prescribe capital adequacy norms, including a minimum capital adequacy ratio level of around 8% in the world and 9% and above in India, to ensure bank health and avert financial crises.

Supports Lending:

Banks with adequate capital can maintain lending to individuals and businesses and allocate resources for financial operations, thereby contributing to the stability and growth of the economy.

Facilitates Lending and Expansion:

Banks that are well-capitalized can safely lend to consumers and businesses, fuelling economic expansion and development.

Avoids Bank Collapses:

By imposing minimum capital, CAR reduces the risk of bank failures and thus enhances the overall stability of the financial system.

What is the Capital Adequacy Ratio Formula?

The capital adequacy ratio formula evaluates the proportion of a bank's capital against its risk-weighted assets. This metric, also known as the CRAR ratio, reflects the bank's capacity to withstand potential financial losses and sustain its financial health and stability.

Formula:

CAR (%) = (Tier 1 Capital + Tier 2 Capital) ÷ Risk-Weighted Assets × 100

Example

Suppose a bank has:

• Tier 1 Capital: INR 500 crore
• Tier 2 Capital: INR 200 crore
• Risk-Weighted Assets: INR 6,000 crore

CAR (%) = (500 + 200) ÷ 6,000 × 100 = 11.67%

This means the bank has a CAR of 11.67%, which is above the RBI’s minimum requirement of 9% for Indian banks, indicating financial stability and regulatory compliance.

Components of Capital Adequacy Ratio

The capital adequacy ratio in India is divided into tiers to reflect the quality and reliability of a bank’s capital. Each tier represents a different level of strength in absorbing losses, as prescribed by capital adequacy norms.

Tier 1 Capital

• Considered the core capital of a bank.
• Includes equity capital, disclosed reserves, and retained earnings.
• Most reliable, as it is permanently available to cover losses.

Tier 2 Capital

• Known as supplementary capital.
• Includes subordinated debt, revaluation reserves, and hybrid instruments.
• Provides an additional cushion but is less permanent than Tier 1.

Tier 3 Capital

• Introduced under earlier Basel norms to cover market risk.
• Consisted mainly of short-term subordinated debt.
• Phased out under Basel III; banks now rely mainly on Tier 1 and Tier 2.

Risk-Weighted Assets (RWA)

• Represent the risk level of a bank’s assets, such as loans and investments.
• Safer assets (like government bonds) carry lower weights, while riskier loans carry higher weights.
• Used in the CAR formula to ensure banks with higher risk exposures maintain higher levels of capital.

These norms ensure that the CAR in banking is sufficient to safeguard depositors and maintain financial stability.

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Regulatory Standards for Capital Adequacy Ratio (CAR)

The Reserve Bank of India (RBI) has based the regulatory standards for Capital Adequacy Ratio on Basel norms:

Minimum CAR Requirement:

Indian Banks must maintain a minimum capital adequacy ratio of 9% for most banks and 12% for public sector banks. This means banks must maintain this percentage of their risk-weighted assets as capital to absorb losses and stay safe.

Capital Conservation Buffer:

RBI mandates to hold an additional 2.5% buffer over the minimum CAR to ensure banks have extra capital during financial stress, making the effective CAR requirement higher.

Risk-Weighted Assets (RWA):

Banks calculate CAR based on the riskiness of their assets. Loans and investments are assigned risk weights, and banks need to maintain capital in proportion to these risk-weighted amounts.

Regular Monitoring and Compliance:

RBI closely monitors CAR in banking and can intervene if banks fall below required levels. This may include requiring banks to raise capital, restrict dividends, or limit lending until the CRAR ratio is restored.

Limitation of Using CAR

The capital adequacy ratio in India serves as a key measure of banking stability; however, it has certain limitations.

Focus on Quantity, Not Quality:

CAR highlights how much capital a bank holds but does not fully capture the quality of assets or the effectiveness of risk management practices.

Backward-Looking Measure:

It is based on current and past financial data, which may not reflect emerging risks or sudden market shocks.

Complexity of Risk Weights:

Assigning weights to different assets can sometimes oversimplify or misrepresent actual risk, especially in volatile markets.

Ignores Liquidity Risk:

CAR assesses solvency but does not measure a bank’s ability to generate cash quickly to meet short-term obligations.

Regulatory Differences:

Banks must comply with capital adequacy norms, which differ across countries. This can make international comparisons challenging.

Potential for Manipulation:

Banks may restructure portfolios to appear compliant with CAR norms without genuinely strengthening their financial position.

Factors Affecting Capital Adequacy Ratio

The Capital Adequacy Ratio is influenced by several factors that are specific to the Indian banking and regulatory environment. Here are the key factors affecting CAR in India:

Economic Conditions:

The broader economic environment in India, including GDP growth, inflation, and interest rates, influences the risk weightings of assets and the overall business environment, affecting capital adequacy.

Bank Mergers and Consolidation:

The Indian banking sector has seen consolidation as part of reform measures, which affects capital base and CAR calculations due to revaluation of assets and liabilities.

Foreign Exchange Fluctuation:

With exposure to foreign currency loans and deposits, exchange rate fluctuations can impact the valuation of risk-weighted assets and capital.

Government and RBI Support:

Capital infusion by the government in public sector banks has been a recurring strategy to strengthen their capital base, improving the CAR.

Market Risk and Operational Risk Management:

The ability of banks to manage market and operational risks effectively influences the amount of capital required to be held, thus impacting the CAR.

Growth in Advances and Liabilities:

Rapid growth in advances without commensurate capital increase can affect CAR negatively, as it increases risk-weighted assets.

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What's the Minimum Capital Adequacy Ratio Allowed?

Globally, under Basel III norms, banks must maintain a minimum Capital Adequacy Ratio (CAR) of 8% of risk-weighted assets. In practice, many jurisdictions also apply a capital conservation buffer, raising the effective requirement closer to 10.5%.

In India, the Reserve Bank of India (RBI) sets stricter thresholds:

• Scheduled Commercial Banks: Minimum CAR of 9%
• Public Sector Banks: Minimum CAR of 12%, to provide an added cushion against stressed assets

A higher CRAR ratio indicates stronger financial resilience, while banks that fall below these levels face regulatory intervention to restore capital and safeguard depositors.

What Are the Basel Accords?

The Basel Accords are international agreements created by the Basel Committee on Banking Supervision (BCBS) to make banks around the world safer and more reliable. They set common rules on how much capital banks must keep aside to cover potential losses, how risks should be measured, and how supervisors should oversee banking practices.

In simple terms, the Basel Accords act like a safety checklist for banks worldwide, ensuring they remain strong enough to protect depositors and maintain financial stability during uncertain times.

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Conclusion

The Capital Adequacy Ratio (CAR) remains a cornerstone of banking stability, ensuring that financial institutions can absorb shocks, protect depositors, and support sustainable growth. While it has certain limitations, CAR continues to guide both regulators and banks in safeguarding the financial system. For individuals seeking stability in wealth management, you can open a Wealth Account with DBS Treasures to build on the same principles of resilience and security.

Frequently Asked Questions (FAQs) about Capital Adequacy Ratio (CAR)

1. Is CAR the same as CRAR ratio?

   Yes. CAR and CRAR ratio both stand for Capital to Risk-Weighted Assets Ratio. Regulators and banks use these terms interchangeably to measure financial strength.

2. Why is CAR in banking important for customers?

   CAR in banking assures depositors that their money is safe. A higher CAR means the bank is better positioned to absorb unexpected losses and continue lending, even during economic stress.

3. What are capital adequacy norms and how do they affect banks?

   Capital adequacy norms are rules set by regulators like the RBI to ensure banks maintain sufficient capital. These norms influence how much a bank can lend, invest, or expand while keeping depositor funds secure.

4. What is the minimum capital adequacy ratio prescribed in India?

   Globally, Basel III recommends a minimum capital adequacy ratio of 8%. The RBI sets stricter standards—9% for most banks and 12% for public sector banks—making Indian banks more resilient.

5. How does CAR impact a bank’s lending capacity?

   A higher CAR allows a bank to expand its lending safely, as it shows strong capital backing against risk-weighted assets. If a bank’s CAR falls close to the minimum capital adequacy ratio, regulators may restrict its lending until it strengthens its capital base.

6. Does the Capital Adequacy Ratio affect NRI Savings Accounts?

   The Capital Adequacy Ratio (CAR) reflects a bank’s overall financial strength and ability to absorb losses. While it does not directly change the features of an NRI Savings Account, a higher CAR indicates greater stability of the bank, which helps safeguard customer deposits, including those held by NRIs.

Disclaimer – The information provided in this article is for general informational purposes only. For specific guidance or details, please consult with your Relationship Manager or relevant expert.