What is Capital Adequacy Ratio ?
The capital adequacy ratio (CAR) measures how much capital a bank has in comparison to its current obligations and risk-weighted assets. Central banks and bank regulators make the decision to stop commercial banks from using excessive leverage and going bankrupt as a result. The capital adequacy ratio, also referred to as the capital-to-risk weighted assets ratio (CRAR), is used to safeguard depositors and support the global financial systems' stability and effectiveness. There are two kinds of capital that are measured: tier-1 capital, which can absorb losses without requiring a bank to stop operating, and tier-2 capital, which can absorb losses in the case of a winding-up but offers less protection to depositors.
To get a bank's capital adequacy ratio, the two capital tiers are combined together and divided by risk-weighted assets. By looking at a bank's loans, assessing the risk, and then applying a weight, risk-weighted assets are calculated. Adjustments are made to the value of assets listed on a lender's balance sheet when calculating credit exposures. Based on the level of credit risk associated with each loan the bank has made, each loan is given a weight.
Basel III standards required an 8% capital to risk-weighted assets ratio. According to RBI regulations, Indian public sector banks are required to maintain a CAR of 12% whereas Indian scheduled commercial banks are obligated to keep a CAR of 9%.
Why does Capital Adequacy Ratio matter ?
Minimum capital adequacy ratios (CARs) are important because they ensure that banks have enough reserve capital to absorb some losses before going bankrupt and losing depositor money as a result. By reducing the likelihood of bank insolvency, capital adequacy ratios promote the effectiveness and stability of a country's financial system. A bank with a high capital adequacy ratio is typically regarded as secure and likely to fulfil its financial obligations. Depositors can only lose their savings if a bank experiences a loss that exceeds the capital it has on hand since depositor funds are prioritised over the bank's capital throughout the winding-up procedure. Thus the higher the bank’s capital adequacy ratio, the higher the degree of protection of depositor's assets.
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