Definition of Capital Adequacy Ratio
In the banking system, the term “capital adequacy ratio” refers to the assessment of the bank capital to be maintained corresponding to the risk-weighted credit exposures. The capital adequacy ratio is also known as capital to risk-weighted assets ratio. The ratio was introduced with the objective to protect the bank depositors by promoting stability and efficiency in the banking systems across the world. The ratio is decided by the central banks for the respective countries (like the Federal Reserve for the United States of America) in order to prevent the commercial banks from indulging in exorbitantly high leverage that may eventually result in its insolvency. The CAR truly kicked in after the financial crisis in 2008 when the Bank of International Settlements (BIS) decided to introduce some restrictions and requirements for the banks to protect the depositors.
In the ideal scenario, a financial institution is expected to have a CAR higher than the threshold limit which indicates that it has a sufficient amount of capital to withstand any unexpected losses during times of economic downturns. On the other hand, a low CAR indicates that the financial institution is at a higher risk of failure during any economic disruption.
Formula
The formula for capital adequacy ratio can be derived by dividing the sum of Tier I and Tier II capital maintained by the subject bank by its risk-weighted assets. Mathematically, it is represented as,
The Tier 1 capital in the numerator primarily includes ordinary share capital, intangible assets, future tax benefits, audited revenue reserves, etc., while Tier II capital includes unaudited retained earnings, revaluation reserves, general provisions for bad debts, perpetual cumulative preference shares, perpetual subordinated debt, subordinated debt, etc. Risk-weighted assets, on the other hand, involves a very complex method of evaluating a bank’s loan book to determine its credit risk, market risk and operational risk which ultimately gives the risk-weighted assets.
Examples of Capital Adequacy Ratio (With Excel Template)
Let’s take an example to understand the calculation of the Capital Adequacy Ratio formula in a better manner.
Example – #1
Let us take the example of a bank for which the following information pertaining to its risk capital and loan book is available:
Based on the given information, calculate the capital adequacy ratio for the bank and check if it complies with the minimum requirement of 10%.
Solution:
Risk-Weighted Assets is calculated as
- Risk-Weighted Assets = $10.00 Mn * 90% + $50.00 Mn * 60% + $5.00 Mn * 0%
- Risk-Weighted Assets = $39.00 Mn
Capital Adequacy Ratio is calculated by using the formula given below
Capital Adequacy Ratio = (Tier I Capital + Tier II Capital) / Risk-Weighted Assets
- CAR = ($3.00 Mn + $1.00 Mn) / $39.00 Mn
- CAR = 10.3%
Therefore, the bank satisfies the minimum requirement of 10% set by the regulatory bodies.
Example – #2
Let us now take the example of Bank of America to calculate the capital adequacy ratio. According to the annual report for the year 2018, the following information is available (under advanced approach):
Based on the given information, calculate the capital adequacy ratio of Bank of America for the year 2018.
Solution:
Tier I Capital is calculated as
Tier I Capital = Common Equity Tier I Capital + Qualifying Preferred Stock + Other Tier I Capital
- Tier I Capital = $167.27 Bn + $22.33 Bn + ($0.56 Bn)
- Tier I Capital = $189.04 Bn
Tier II Capital is calculated as
Tier II Capital = Tier II Capital Instruments + Eligible Credit Reserves Included in Tier-II Capital + Other Tier II Capital
- Tier II capital = $21.89 Bn + $1.97 Bn + ($0.02 Bn)
- Tier II capital = $23.84 Bn
Now, the capital adequacy ratio for Bank of America can be calculated by using the above formula as,
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Capital Adequacy Ratio = (Tier I Capital + Tier II Capital) / Risk-Weighted Assets
- CAR = ($189.04 Bn + $23.84 Bn) / $1,409 Bn
- CAR = 15.1%
Therefore, the capital adequacy of the Bank of America stood at 15.1% for the year 2018 under the advanced approach.
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Advantages and Disadvantages of Capital Adequacy Ratio
Some of the advantages and disadvantages of CAR are as follows:
Advantages
- It helps the banks to maintain capital based on the riskiness of each loan exposure. For instance, two banks with the same loan book size but a different level of portfolio risk will be required to maintain corresponding bank capital. Higher the risk, the higher the capital required.
- The ratio is a good indicator for the investors to understand the overall risk of the loan book of a bank.
Disadvantages
One major limitation of the capital adequacy ratio is that it is unable to account for the expected losses that can deform a bank’s capital during any financial crisis.
Conclusion
So, the capital adequacy ratio is a risk measure for the commercial banks that helps the regulatory bodies to keep a close track of the risk level of bank lending.
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