Last editedOct 20202 min read
Keeping a close eye on your business’s capital is essential, but banks aren’t exempt from this sort of scrutiny. Find out everything you need to know about capital adequacy ratio right here.
What is capital adequacy ratio?
Capital adequacy ratio (CAR), also known as the capital to risk adequacy ratio (CRAR), is a measurement of a bank’s available capital, which is used to respond to credit risks and liabilities. A good capital adequacy ratio ensures a bank can absorb any potential losses and decrease their risk of becoming insolvent. Therefore, it ensures that the bank is adequately equipped to protect the money of their depositors in the face of financial challenges.
How is CAR calculated?
Capital adequacy ratio measures two types of capital:
Simply put, this is the capital a bank has to keep it functioning even through riskier transactions like loans and trading. Tier-1 capital helps reflect the financial strength of a bank. Tier-1 capital includes:
Tier-2 capital is considered less secure than Tier-1 and is more of a supplementary layer to the security offered by Tier-1. Tier-2 includes:
Revaluation reserves: An example of this is the value of the bank’s building, which can increase in time and must be revalued
It also takes into account risk-weighted assets. These determine how much capital a bank needs to reduce the risk of insolvency. They are calculated by considering the bank’s loans and assigning a weighting to the risk these represent. Loans will have different weighting depending on their perceived credit risk.
How are risk-weighted assets in the CRAR formula calculated?
The idea of risk-weighted assets was put in place by Basel III, also known as the Basel Standards, a regulatory framework responsible for the liquidity coverage ratio. Put simply, the idea behind risk-weighted assets was to help strengthen global banks following the events of the financial crisis in 2007-8, when it was discovered many banks were not resilient enough to survive. The framework requires banks to group assets by risk category. For example:
A government loan has a risk level of 0% as the government guarantees it
A mortgage has a risk level that can be anything from 35-200% as they are not guaranteed
A loan with a letter or credit will be ranked as riskier than a loan secured with collateral
A bank may have fewer assets than another. Still, suppose those assets are less risky. In that case, mortgages with the property as collateral, then the bank with fewer assets will be considered safer and have a higher capital adequacy ratio than another bank that only has customer loans with no collateral.
Some banks in Australia, especially the larger names, will use their internal weighting system to decide which assets have the highest risk when making their capital adequacy ratio calculation. This process must be approved by APRA and adhere to their strict guidelines.
How to calculate capital adequacy ratio with example
The capital adequacy process takes both Tier-1 and Tier-2 capital into account using the following CRAR formula:
So, using this capital adequacy ratio calculation, you know that if a bank has $5 million in Tier-1 Capital and $2 million in Tier-2 Capital, and calculated Risk-Weighted Assets of $20 million, the capital adequacy ratio calculation is as follows:
This means the capital adequacy ratio of this bank is 35%.
What is a good capital adequacy ratio?
In Australia, at least half of the bank’s total capital must be Tier-1 Capital, providing a minimum Tier-1 ratio of 4%. In June 2020, Australia’s national CAR was 16.3%. By comparison, a CAR of 35% is a strong rating for a bank, making it a secure institution.
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