CAPITAL ADEQUACY RATIO (CAR)

As shown below, the CAR formula is:

 The Bank of International Settlements (BIS) 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.
 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.
 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.
I) Asset classes that are safe, such as government debt, have a risk weighting
close to 0%.
II) 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.
III) 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 the 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

Using CAR formula:

The Capital Adequacy Ratio of Bank A is as follows:

CAR = RM3,000 + RM1,000

RM 41,850
= 9.56%

As Bank A has a car of 9.56%, 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%.