Capital Adequacy Ratio - CAR

A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit

exposures.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."

This ratio is used to protect depositors and promote the stability and efficiency of financial
systems around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank
being required to cease trading, and tier two capital, which can absorb losses in the event of a
winding-up and so provides a lesser degree of protection to depositors.

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%

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,
Rama Mittal, Asst. Professor 1
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:

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

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,

Use of CAR

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.[1]

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.

Rama Mittal, Asst. Professor 2