What is a capital adequacy ratio, and what does it mean?
The phrase capital adequacy ratio and what it means in the banking industry are explained in this article.
The capital adequacy ratio (CAR) is the relationship between a bank’s available capital and the risks associated with loan distribution. Capital adequacy ratio, also known as capital-to-risk weighted asset ratio, is a credit solvency management method used by banking authorities to assist banks stay financially healthy (CRAR).
Banking authorities frequently require banks to hold a specific amount of their debt exposure as assets. This rate is stated in percentages and is known as the bank’s capital adequacy ratio. The capital adequacy ratio, in basic words, indicates how much capital a bank has in relation to its overall debt exposure.
What is the purpose of the capital adequacy ratio?
National banking regulators, such as the Reserve Bank of India (RBI), and international banking standards, such as BASEL, impose capital adequacy ratios on banks to prevent them from over-leveraging and becoming debt-laden in the process, without sufficient liquidity to act as a cushion in the event of a monetary shock.
Banking regulators impose financial discipline among banks and preserve the general health of the banking system in this manner, therefore protecting depositors’ investments.
Maintaining the capital-to-risk-weighted-asset ratio makes banks more robust in the face of financial turbulence, such as the global financial crisis of 2008 or the more localised non-banking financing crisis of 2019.
The capital adequacy ratio is calculated using a formula.
(Tier I + Tier II + Tier III (Capital funds) /Risk weighted assets) is the formula used to calculate capital adequacy ratio.
There are three forms of capital that are included when calculating a bank’s capital adequacy ratio:
Tier-I capital consists of: This is the bank’s asset that can let it absorb any shock without having to shut down operations. Tier-I capital, which includes shareholders’ equity and retained earnings, is a bank’s core capital.
Tier-II capital: This is the bank’s asset that can absorb losses if the bank is forced to close. Revaluation reserves, hybrid capital instruments, and subordinated term debt make up a bank’s Tier-II capital.
Tier-III capital: is made up of a combination of Tier-II and short-term subordinated loans.
What exactly is Basel-III?
Basel-III is an international regulatory standard that specifies standards for banking supervision.
In 2021, the capital adequacy ratio will be
As of 2021, banks must have a minimum capital adequacy ratio of 8% under Basel-III. However, incorporating the capital conservation buffer, the required capital adequacy ratio is 10.5 percent. Capital adequacy ratios under Basel-III regulations are higher than the Basel-II minimum criteria.
While a lower capital adequacy rate allows banks to lend more, it also puts them at risk. A high capital adequacy rate, on the other hand, will limit a bank’s ability to lend while also assisting it in maintaining fiscal health.
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