Capital Adequacy Ratio helps in measuring the financial strength or the ability of the financial institutions in meeting its obligations using its assets and capital and it is calculated by dividing capital of the bank by its risk-weighted assets.
What is Capital Adequacy Ratio?
Capital adequacy ratio is a measure to find out the proportion of banks capital, with respect to the total risk-weighted assets of the bank. The credit risk attached to the assets depends on the entity the bank is lending loans to, for example, the risk attached to a loan it is lending to the government is 0%, but the amount of loan lends to the individuals is very high in percentage.
- The ratio is represented in the form of a percentage, generally higher percentage implies for safety. A low ratio indicates that the bank does not have enough capital for the risk associated with its assets, and it can go bust with any adverse crisis, something which happened during the recession.
- A very high ratio can indicate that the bank is not utilizing its capital optimally by lending to its customers. Regulators worldwide have introduced Basel 3, which requires them to maintain higher capital with respect to the risk in the books of the company, in order to protect the financial systems from another major crisis.
Formula
- The total capital, which is the numerator in the capital adequacy ratio, is the summation of Tier 1 capital of the bank and tier 2 capitalTier 2 CapitalTier 2 capital, also known as supplementary capital, is the second layer of bank capital requirements. It consists of hybrid instruments, general provisions and revaluation reserves. Uneasy to liquidate; Tier 2 capital is considered less secure.read more of the bank.
- The tier 1 capital, which is also known as the common equity tier 1 capital, includes mainly share capital, retained earnings, other comprehensive income, intangible assetsIntangible AssetsSome of the most common intangible assets are logos, self-developed software, customer data, franchise agreements, Newspaper Mastheads, license, royalty, Marketing Rights, Import Quotas, Servicing Rights etc.read more, and other small adjustments.
- The tier 2 capital of a bank includes revaluation reserves, subordinated debt, and related stock surpluses.
- The denominator is risk-weighted assets. The risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement.read more of a bank include credit risk-weighted assets, market risk-weighted assets, and operational risk-weighted assets. The ratio is represented in the form of a percentage; generally higher percentage implies safety for the bank.
The mathematical representation of this Formula is as follows –
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For eg:
Source: Capital Adequacy Ratio (wallstreetmojo.com)
Calculation Examples (with Excel Template)
Let’s see some simple to advanced examples to understand it better.
Example #1
Let us try to understand the CAR of an arbitrary bank in order to understand how to calculate the ratio for banks. For the calculation of CAR, we need to assume the tier 1 and tier 2 capital of the bank. We also need to assume the risk associated with its assets; those risks weighted assets are Credit risk-weighted assets, and Market risk-weighted assets and Operational risk-weighted assets.
The snapshot below represents all the variables required to calculate the CAR.
For the calculation of the Capital Adequacy ratio formula, we will first calculate the Total Risk-weighted assets as follows,
Total Risk-weighted Assets = 1200+350+170 =1720
The calculation of the Capital Adequacy ratio formula will be as follows,
CAR Formula = (148+57) /1720
CAR will be –
CAR = 11.9%
The ratio represents the CAR for the bank is 11.9%, which is a pretty high number and is optimal to cover the risk it is carrying in its books for the assets it holds.
Example #2
Let us try to understand the CAR for State Bank of India. For calculation of Capital Adequacy Ratio (CAR), we need the numerator, which is the tier 1 and tier 2 capital of the bank. We also need the denominator, which is the risk associated with its assets; those risks weighted assets are Credit risk-weighted assets, Market risk-weighted assets, and Operational risk-weighted assets.
The snapshot below represents all the variables required to calculate the CAR formula.
For the calculation, we will first calculate the Total Risk-weighted assets as follows,
The calculation of Capital adequacy ratio will be as follows,
CAR Formula = (201488+50755) / 1935270
CAR will be –
Example #3
Let us try to understand the CAR for ICICI. For the calculati0n of Capital adequacy ratio, we need the numerator, which is the tier 1 and tier 2 capital of the bank. We also need the denominator, which is the risk-weighted assets.
The snapshot below represents all the variables required to calculate the Capital adequacy ratio.
For the calculation of Capital adequacy ratio, we will first calculate the Total Risk-weighted assets as follows,
Total Risk-weighted assets =5266+420+560 = 6246
The calculation of Capital adequacy ratio will be as follows,
CAR Formula = (897+189) / 6246
CAR will be –
Capital Adequacy Ratio =17.39%
The ratio represents the CAR for the bank is 17.4%, which is a pretty high number and is optimal to cover the risk it is carrying in its books for the assets it holds. Also, find below the snapshot for the company reported numbers.
Relevance and Use
CAR is the capital that is set aside by the bank that acts as a cushion for the bank for the risk associated with the assets of the bank. A low ratio indicates that the bank does not have enough capital for the risk associated with its assets. Higher ratios will signal safety for the bank. It plays a very important role in analyzing banks globally post-subprime crisis.
A lot of banks have been exposed, and their valuation plummeted as they were not maintaining the optimal amount of capital for the amount of risk they had in terms of credit, market, and operational risks in their books. With the introduction of the Basel 3 measure, the regulators have made the requirements for more stringent from earlier Basel 2, to avoid one more crisis in the future. In India, a lot of public sector banks have fallen short of CET 1 capital, and the government has been infusing these requirements over the last few years.
You can download this Excel Template from here – Capital Adequacy Ratio Formula Excel Template
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This article has been a guide to Capital Adequacy Ratio and its definition. Here we discuss the formula to calculate Capital Adequacy Ratio (CAR) with the practical examples and a downloadable excel sheet. You can learn more about accounting from the following articles –
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