Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio

(CRAR), is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to
ensure that it can absorb a reasonable amount of loss and are complying with their statutory
Capital requirements.This ratio is used to protect depositors and promote the stability and
efficiency of financial systems around the world.

What Does Basel Accord Mean?

A set of agreements set by the Basel Committee on Bank Supervision (BCBS), which
provides recommendations on banking regulations in regards to capital risk, market risk and
operational risk. The purpose of the accords is to ensure that financial institutions have
enough capital on account to meet obligations and absorb unexpected losses.

The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital
adequacy of financial institutions. The capital adequacy risk, (the risk that a financial
institution will be hurt by an unexpected loss), categorizes the assets of financial institution
into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are
required to have a risk weight of 8% or less.

The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses
on three main areas, including minimum capital requirements, supervisory review and market
discipline, which are known as the three pillars. The focus of this accord is to strengthen
international banking requirements as well as to supervise and enforce these requirements.

Formula

Capital adequacy ratios ("CAR") are a measure of the amount of a bank's core capital
expressed as a percentage of its assets weighted credit exposures.

Capital adequacy ratio is defined as

TIER 1 CAPITAL -A)Equity Capital, B) Disclosed Reserves

TIER 2 CAPITAL -A)Undisclosed Reserves, B)General Loss reserves, C)Subordinate Term

Debts

where Risk can either be weighted assets ( ) or the respective national regulator's minimum
total capital requirement. If using risk weighted assets,

≥ 10%.

The percent threshold varies from bank to bank (10% in this case, a common requirement for
regulators conforming to the Basel Accords) is set by the national banking regulator of
different countries.
Two types of capital are measured: tier one capital (T1 above), which can absorb losses
without a bank being required to cease trading, and tier two capital (T2 above), which can
absorb losses in the event of a winding-up and so provides a lesser degree of protection to
depositors.

Use

Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of
meeting the time liabilities and other risks such as credit risk, operational risk, etc. In the
most simple formulation, a bank's capital is the "cushion" for potential losses, which protects
the bank's depositors or other lenders. Banking regulators in most countries define and
monitor CAR to protect depositors, thereby maintaining confidence in the banking system.

CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of
debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-
to-equity; since assets are by definition equal to debt plus equity, a transformation is
required). Unlike traditional leverage, however, CAR recognizes that assets can have
different levels of risk.

Risk weighting

Since different types of assets have different risk profiles, CAR primarily adjusts for assets
that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR
calculation vary from country to country, but general approaches tend to be similar for
countries that apply the Basel Accords. In the most basic application, government debt is
allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of
calculating the CAR.

Risk weighting example

Risk weighted assets - Fund Based : Risk weighted assets mean fund based assets such as
cash, loans, investments and other assets. Degrees of credit risk expressed as percentage
weights have been assigned by RBI to each such assets.

Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance
sheet items has to be first calculated by multiplying the face amount of each of the off-
balance sheet items by the credit conversion factor. This will then have to be again multiplied
by the relevant weightage.

Local regulations establish that cash and government bonds have a 0% risk weighting, and
residential mortgage loans have a 50% risk weighting. All other types of assets (loans to
customers) have a 100% risk weighting.

Bank "A" has assets totaling 100 units, consisting of:

• Cash: 10 units.
• Government bonds: 15 units.
• Mortgage loans: 20 units.
• Other loans: 50 units.
 • Other assets: 5 units.

Bank "A" has debt of 95 units, all of which are deposits. By definition, equity is equal to
assets minus debt, or 5 units.

Bank A's risk-weighted assets are calculated as follows

Cash 10 * 0% = 0
Government securities 15 * 0% = 0
Mortgage loans 20 * 50% = 10
Other loans 50 * 100% = 50
Other assets 5 * 100% = 5
Total risk Weighted Assets = 65

Equity 5
CAR (Equity/RWA) 7.69%

Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equity-to-assets
of only 5%, its CAR is substantially higher. It is considered less risky because some of its
assets are less risky than others.

Types of capital

The Basel rules recognize that different types of equity are more important than others. To
recognize this, different adjustments are made:

1. Tier I Capital: Actual contributed equity plus retained earnings.

2. Tier II Capital: Preferred shares plus 50% of subordinated debt.

Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets
may be 4%, while minimum CAR including Tier II capital may be 8%.

There is usually a maximum of Tier II capital that may be "counted" towards CAR,
depending on the jurisdiction.

Capital Adequacy Ratio in India

The Committee on Banking Regulations and Supervisory Practices (Basel Committee)

had released the guidelines on capital measures and capital standards in July 1988 which
were been accepted by Central Banks in various countries including RBI. In India it has
been implemented by RBI w.e.f. 1.4.92

Objectives of CAR : The fundamental objective behind the norms is to strengthen the
soundness and stability of the banking system.

Capital Adequacy Ratio or CAR or CRAR : It is ratio of capital fund to risk weighted
assets expressed in percentage terms i.e.
Minimum requirements of capital fund in India:
* Existing Banks 09 %
* New Private Sector Banks 10 %
* Banks undertaking Insurance business 10 %
* Local Area Banks 15%

Tier I Capital should at no point of time be less than 50% of the total capital. This implies
that Tier II cannot be more than 50% of the total capital.

Capital fund

Capital Fund has two tiers - Tier I capital include

*paid-up capital
*statutory reserves
*other disclosed free reserves
*capital reserves representing surplus arising out of sale proceeds of assets.
Minus
*equity investments in subsidiaries,
*intangible assets, and
*losses in the current period and those brought forward from previous periods
to work out the Tier I capital.

Tier II capital consists of:

*Un-disclosed reserves and cumulative perpetual preference shares:
*Revaluation Reserves (at a discount of 55 percent while determining their value for
inclusion in Tier II capital)
*General Provisions and Loss Reserves upto a maximum of 1.25% of weighted risk
assets:
*Investment fluctuation reserve not subject to 1.25% restriction
*Hybrid debt capital Instruments (say bonds)
*Subordinated debt (long term unsecured loans)

Risk weighted assets - Fund Based : Risk weighted assets mean fund based assets such
as cash, loans, investments and other assets. Degrees of credit risk expressed as
percentage weights have been assigned by RBI to each such assets.

Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-
balance sheet items has to be first calculated by multiplying the face amount of each of
the off-balance sheet items by the credit conversion factor. This will then have to be again
multiplied by the relevant weightage.

Reporting requirements :
Banks are also required to disclose in their balance sheet the quantum of Tier I and Tier II
capital fund, under disclosure norms. An annual return has to be submitted by each bank
indicating capital funds, conversion of off-balance sheet/non-funded exposures,
calculation of risk -weighted assets, and calculations of capital to risk assets ratio.

CAR in USA
The tier 1 risk-based capital ratio (tier 1 CAR) is tier 1 capital divided by risk-weighted
assets. Tier 1 capital is the sum of core capital elements (capital stock, surplus, undivided
profits, qualifying noncumulative perpetual preferred stock and minority interest in the
equity accounts of consolidated subsidiaries) less goodwill and other intangible assets.
Tier 1 capital does not include any gains or losses on available-for-sale securities. For
most community banks, tier 1 capital is simply capital stock, surplus and undivided
profits.

Risk-weighted assets are calculated by assigning each asset and off-balance-sheet item to
one of four broad risk categories. These categories are assigned risk weights of 0 percent,
20 percent, 50 percent, and 100 percent. Riskier assets are placed in the higher percentage
categories. For example, the 0 percent category includes cash and U.S. Treasury
securities, while loans are generally in the 100 percent category. Risk-weighted assets,
tier 1 capital, tier 2 capital and all three of the aforementioned capital ratios (tier 1
leverage, tier 1 risk-based and total risk-based) are also included in your bank’s quarterly
Call Report.

Banks are expected to meet a minimum tier 1 risk-based capital ratio of 4 percent.

The total risk-based capital ratio (total CAR) is the sum of tier 1 and tier 2 capital divided
by risk-weighted assets. Tier 2 capital is the sum of the allowance for loan and lease
losses (limited to 1.25 percent of risk-weighted assets), perpetual preferred stock not
qualifying as tier 1 capital, subordinated debt and intermediate term preferred stock. Tier
2 capital cannot exceed tier 1 capital. For most community banks, tier 2 capital is simply
the allowance for loan and lease losses (limited to 1.25 percent of risk-weighted assets).

Banks are expected to meet a minimum total risk-based capital ratio of 8 percent.

Because risk-based capital ratios do not take explicit account of the quality of individual
asset portfolios or of other types of risk to which a bank may be exposed (including
interest rate, liquidity, market and operational risks), banks are generally expected to
operate with positions above the minimums. In determining capital adequacy, various
risks and exposures need to be taken into account:

Higher-risk banks, in particular, should maintain capital well above the minimums.
Higher-risk banks include those growing aggressively as well as those with weaker asset
quality, earnings or management. Large exposures from litigation or from off-balance-
sheet items also require additional capital.

Calculation Example

Because off-balance sheet credit exposures are included in calculations, capital adequacy
ratios cannot be calculated by reference to the balance sheet alone. Even the calculation of
capital adequacy ratios to cover on-balance sheet credit exposures usually cannot be done
by using published balance sheets, as these will probably not provide sufficient detail about
who the bank has lent to, or the issuers of securities held by the bank. However, the
disclosure statements of the bank should contain the information necessary to confirm the
bank's capital adequacy ratio calculations.
To illustrate the process a bank goes through in calculating its capital adequacy ratios, a
simple worked example is contained in Figures 1 to 5. The steps in the calculation are
explained below. The balance sheet information and the off-balance sheet credit exposures
on which the calculations are based are set out in Figures 1 and 2.

Figure 1:Balance Sheet

Assets Liabilities & Equity
Cash 11 Deposits 182
5 Year Govt. Stock 20 Subordinated term debt 2
Lending to Banks 30 Shareholders' Funds
Housing loans with mortgages 52 Ordinary capital 7
Commercial loans 64 Redeemable preference shares 3
Goodwill 3 Retained earnings 8
Shareholding in other bank 3 Revaluation reserve 4
Fixed assets 25
General provision for bad debts -2
Total Assets 206 Total Liabilities 206

Figure 2:Off-Balance sheet exposures

Nominal Principal Amount
Direct credit substitute (guarantee of financial obligations) 10
Asset sale with recourse 18
Commitment with certain drawdown (forward purchase of assets) 23
Transaction related contingent item (performance bond) 8
Underwriting facility 28
Short term self liquidating trade related contingency 30
6 month forward foreign exchange contract (replacement cost = 4) 100
4 year interest rate swap (replacement cost = 4) 200
Total 417
Note: The foreign exchange contract and interest rate swap are with banks. All other
transactions are with non-bank customers.

First Step - Calculation of Capital

The composition of the categories of capital is as follows:

Tier One Capital
In general, this comprises:
_ the ordinary share capital (or equity) of the bank; and
_ audited revenue reserves e.g.. retained earnings; less
_ current year's losses;
_ future tax benefits; and
_ intangible assets, e.g. goodwill.
Upper Tier Two Capital
In general, this comprises:
_ unaudited retained earnings;
_ revaluation reserves;
_ general provisions for bad debts;
_ perpetual cumulative preference shares (i.e. preference shares with no maturity date
whose dividends accrue for future payment even if the bank's financial condition does
not support immediate payment);
_ perpetual subordinated debt (i.e. debt with no maturity date which ranks in priority
behind all creditors except shareholders).
Lower Tier Two Capital
In general, this comprises:
_ subordinated debt with a term of at least 5 years;
_ redeemable preference shares which may not be redeemed for at least 5 years.
Total Capital
This is the sum of tier 1 and tier 2 capital less the following deductions:
_ equity investments in subsidiaries;
_ shareholdings in other banks that exceed 10 percent of that bank's capital;
_ unrealised revaluation losses on securities holdings.
Figure 3 shows an example of a calculation of capital.

Figure 3:Calculation of capital

Tier 1
Ordinary capital 7
Retained earnings 8
less Goodwill -3
Total tier 1 capital 12

Tier 2
Upper tier2
General bad debt provision 2
Revaluation reserve 4
Lower tier2
Subordinated debt 2
Redeemable preference shares 3
Total tier 2 capital 11
Deduction
Shareholding in other bank -3
Total capital(Tier 1 & 2) 20

Second Step - Calculation of Credit Exposures

On-Balance Sheet Exposures

The categories into which all credit exposures are assigned for capital adequacy ratio
purposes, and the percentages the balance sheet numbers are weighted by, are as follows:

Credit Exposure Type Percentage Risk Weighting

Cash 0
Short term claims on governments 0
Long term claims on governments (> 1 year) 10
Claims on banks 20
Claims on public sector entities 20
Residential mortgages 50
All other credit exposures 100

Off-Balance Sheet Credit Exposures

(1) Calculation of Credit Equivalents
Listed below are the categories of credit exposures, and their associated "credit conversion
factor". The nominal principal amounts in each category are multiplied by the credit
conversion factor to get a "credit equivalent amount":
Credit Exposure Type Credit Conversion Factor (%)
Direct credit substitutese.g. guarantees, bills of exchange,
letters of credit,risk participations 100
Asset sales with recourse 100
Commitments with certain drawdown
e.g. forward purchases, partly paid shares 100
Transaction related contracts
e.g. performance bonds, bid bonds 50
Underwriting and sub-underwriting facilities 50
Other commitments with an original maturity more than 1 year 50
Short term trade related contingencies e.g. letters of credit 20
Other commitments with an original maturity of less than 1 year or
which can be unconditionally cancelled at any time 0

The final category of off-balance sheet credit exposures, market related contracts (i.e.
interest rate and foreign exchange rate contracts), is treated differently from the other
categories. Credit equivalent amounts are calculated by adding the following:
(a) current exposure - this is the market value of a contract i.e.. the amount the bank could
get by selling its rights under the contract to another party (counted as zero for contracts
with a negative value); and
(b) potential exposure i.e.. an allowance for further changes in the market value, which is
calculated as a percentage of the nominal principal amount as follows:
Interest rate contracts < 1 year 0%
Interest rate contracts > 1 year 0.5%
Exchange rate contracts < 1 year 1%
Exchange rate contracts > 1 year 5%

Although the nominal principal amount of market related contracts may be large, the credit
equivalent amounts are usually small, and so may add very little to the amount of credit
exposures to be risk weighted.

(2) Calculation of Risk Weighted Credit Exposures

The credit equivalent amounts of all off-balance sheet exposures are multiplied by the same
risk weightings that apply to on-balance sheet exposures (i.e. the weighting used depends
on the type of counterparty), except that market related contracts that would otherwise be
weighted at 100 percent are weighted at 50 percent.
Figure 4 shows an example of a calculation of risk weighted assets.

Figure 4 Calculation of risk weighted exposures On-balance sheet

Exposure type Amount X Risk weighting = Risk weighted exposures
Cash 11 0% 0
5 Year Govt Stock 20 10% 2
Lending to banks 30 20% 6
Home loans 52 50% 26
Commercial loans 64 100% 64
Fixed assets 25 100% 25
Total 123

Off-balance sheet
Exposure type AmountX Credit conversion factorX Risk weighting=Risk weighted exposures
Guarantee 10 100% 100% 10
Asset sale with
Recourse 18 100% 100% 18
Forward purchase 23 100% 100% 23
Performance bond 8 50% 100% 4
Underwriting
Facility 28 50% 100% 14
Trade contingency 30 20% 100% 6

Exposure type (Replacement cost+ Potential exposure) X Risk weighting= Risk weighted exposure
Forward FX
Contract 4 + 1 20% 1
Interest rate swap 4 + 1 20% 1

Total 77

Total risk weighted exposures 200

Third Step - Calculation of Capital Adequacy Ratios

Capital adequacy ratios are calculated by dividing tier one capital and total capital by risk
weighted credit exposures.
Figure 5 shows an example of a calculation of capital adequacy ratios.

Figure 5
Calculation of capital adequacy ratios
Tier 1 capital to total weighted exposures = 12 divided by 200 = 6%
Total capital to total risk weighted exposures = 20 divided by 200 = 10%

Conclusion
Capital adequacy ratios measure the amount of a bank's capital in relation to the amount of
its risk weighted credit exposures. The risk weighting process takes into account, in a
stylised way, the relative riskiness of various types of credit exposures that banks have, and
incorporates the effect of off-balance sheet contracts on credit risk. The higher the capital
adequacy ratios a bank has, the greater the level of unexpected losses it can absorb before
becoming insolvent.
The Basle Capital Accord is an international standard for the calculation of capital adequacy
ratios. The Accord recommends minimum capital adequacy ratios that banks should meet.
In the above calculation, the Reserve Bank applies the minimum standards specified in the
Accord to banks registered in New Zealand. This helps to promote stability and efficiency in
the financial system, and ensures that New Zealand banks comply with generally accepted
international standards.