What is the full form of CAR ?

Introduction

The Capital Adequacy Ratio (CAR) assesses a bank's capital position in relation to the risks it assumes. The greater the CAR, the more probable a bank is to be able to absorb losses without becoming bankrupt. Regulators often require the CAR to ensure that banks have sufficient capital to handle unforeseen losses and maintain financial stability.

The CAR is expressed as a percentage, and regulators have established a minimum value. CAR is calculated using two different types of capital: Tier 1 capital, which consists of stock and other loss-absorbing instruments, and Tier 2 capital, which consists of other loss-absorbing forms of debt.

Calculation of CAR

A bank's capital is divided by its risk-weighted assets to determine its capital adequacy ratio (CAR). The CAR is calculated using the following formula −

$$\mathrm{CAR = (Tier\: 1 \:Capital \:+ \:Tier \:2 \:Capital) / Risk-weighted \:Assets }$$

where −

Tier 1 Capital − The bank's core capital, which consists of equity and stated reserves.

Tier 2 Capital − supplemental capital in the form of subordinated debt and other hybrid instruments.

The value of each asset is multiplied by a risk weight factor that regulators have allocated to it in order to arrive at the risk-weighted assets. Depending on the type of asset and its credit risk, different risk weighting factors apply.

Depending on the jurisdiction, regulators often set a minimum CAR standard for banks that takes into account the size and complexity of the bank, the risks it confronts, and the general state of the economy. Banks that don't comply with the minimum CAR standard risk being fined or having their operations restricted.

Importance of CAR

For banks, regulators, investors, and other stakeholders, the capital adequacy ratio (CAR) is crucial for a number of reasons −

• A bank's stability and ability to bear unforeseen losses are measured by the CAR. A high CAR shows that the bank has sufficient capital to withstand financial shocks like economic downturns or borrower defaults.

• The level of risk in a bank's assets is the foundation for the CAR calculation. This encourages banks to maintain a diversified asset portfolio and better manage their risks.

• Banks must meet minimum CAR standards imposed by regulators in order for them to have sufficient capital to absorb losses. If banks don't follow these guidelines, they risk fines or having their operations restricted.

• Investor trust in a bank's performance and financial stability might rise when the CAR is high. As a result, the bank can experience a reduction in its cost of capital and more investment in its stock or debt instruments.

• A competitive advantage may exist for banks with higher CARs over those with lower CARs since these institutions are regarded as being more reliable and financially healthy. Increased market share and profitability may result from this.

Regulatory Requirements for CAR

The Basel Committee on Banking Supervision, which establishes international standards, or national regulatory bodies, such as the Federal Reserve in the United States, the European Banking Authority in Europe, or the Basel Committee on Banking Supervision, vary by country in terms of the regulatory requirements for the Capital Adequacy Ratio (CAR).

CAR is determined using Basel III, a framework developed by the Basel Committee on Banking Supervision. Banks must maintain a minimum CAR of 8% and a minimum of 4.5% in Tier 1 capital in accordance with Basel III. The overall minimum CAR is increased to 10.5% by the requirement that banks maintain a 2.5% "capital conservation buffer." Banks that don't meet the minimal CAR criteria can have their activities restricted or need to acquire more capital.

Some types of banks, such as those considered to be systemically important or those with large exposures to high-risk assets, may be subject to stricter CAR rules in some jurisdictions. In reaction to alterations in the state of the economy or other elements that impact banks' risk profiles, regulators may also modify the CAR standards.

Conclusion

The ratio of a bank's capital to its risk-weighted assets, or capital adequacy ratio, is a measurement of a bank's financial strength and resilience. As it supports risk management, regulatory compliance, investor confidence, and financial stability, it is a crucial statistic for banks, regulators, investors, and other stakeholders. Regulators work to lower the risk of bank failures and safeguard depositors and other stakeholders by establishing minimum standards and ensuring compliance. A bank with a higher CAR is typically more stable and financially healthy, whereas one with a lower CAR may be more risky.

FAQs

Q1. What happens if a bank's CAR is below the required minimum?

Ans. Banks that don't meet the minimum CAR standard may be liable for fines or have their operations restricted. The bank can be required by regulators to raise more capital or take other actions to strengthen its financial situation.

Q2. When are CAR reports made?

Ans. Banks normally report CAR to regulators on a quarterly basis, and their financial statements make this information available to the public.

Q3. Are there any restrictions on the use of CAR as a gauge of a bank's financial stability?

Ans. The use of CAR as a gauge of a bank's financial health has limitations, yes. It does not consider all risks, such as operational risk, reputational risk, or liquidity risk, that a bank may face. Also, different banks could employ various accounting techniques, which can make it challenging to evaluate CAR between other organizations.