Introduction to Capital Adequacy Ratio (CAR)
Capital Adequacy Ratio (CAR) is the measurement ratio that assesses the ability of banks to absorb losses. It standardizes the banks’ abilities to pay off its liabilities, tackle credit and operational risks. The Central Bank sets the bar on the required number that the CAR must show, thereby helping banks analyse their commercial leverage.
Understanding Capital Adequacy Ratio (CAR)
CAR measures the ratio of two tiers of capitals: tier 1 capital that absorbs the risks during the working of the bank, and tier 2 capital that absorbs losses during its liquidation so as to provide necessary compensation to the customers of the bank. CAR also acts as a stress test for many banks, to determine how much money the bank has to counter the many risks on various sectors and fronts it may face. CAR = Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets The sum of the two tiered capitals is divided by risk weighted assets like loans. These assets are determinants of how much money the bank must hold to reduce the risk of insolvency. The risk weighted assets are indicative of the capital requirement on the basis of the risk assessment made for each of the bank’s assets. Since CAR represents a number that shows the risk cushioning health of the bank, banks are required to maintain a safe, higher number to signify their favourability. CAR allows banks to look into what tier might be subject to suffering, and whether or not it has enough funds to handle the risks of the two tiers and the assets it manages. That the bank is not running into insolvency that will consequently reduce the efficacy of the nation’s money network as well.
Highlights of Capital Adequacy Ratio (CAR)
At the time of winding up of the company, the depositors assets are more important than the company’s own finances. CAR ensures that a layer of safety is present for the bank to manage its own risk weighted assets before it can manage its depositors’ assets. Indian public sector banks must maintain a CAR of 12% while Indian scheduled commercial banks are required to maintain a CAR of 9%.
