capital adequacy

Capital Adequacy Ratio — Meaning and its Importance

capital adequacy

Banks in the modern world face an inherent risk of insolvency. Since the banks are so highly leveraged, there could be a run on the bank any moment if their reserves are considered to be inadequate by the market.

Hence, banks must maintain adequate capital in their vaults if they want to survive. However, what constitutes “adequate” is subjective.

This is generally measured in the form of a “capital adequacy ratio” and central banking institutions all over the world prescribe the level of capital that needs to be maintained.

In this article, we will have a closer look at the capital adequacy ratio and why it is of paramount importance for banking institutions.

Ensuring Solvency of Banks

The capital adequacy ratio is important from the point of view of solvency of the banks and their protection from untoward events which arise as a result of liquidity risk as well as the credit risk that banks are exposed to in the normal course of their business.

The solvency of banks is not a matter that can be left alone to the banking industry. This is because banks have the savings of the entire economy in their accounts. Hence, if the banking system were to go bankrupt, the entire economy would collapse within no time. Also, if the savings of the common people are lost, the government will have to step in and pay the deposit insurance.

Hence, since the government has a direct stake in the issue, regulatory bodies are involved in the creation and enforcement of capital ratios. In addition to that capital ratios are also influenced by international banking institutions.

Limits The Amount of Credit Creation

Theoretically, reserve requirements are supposed to limit the amount of money that can be created by banking institutions.

However, in some countries, the United Kingdom and Canada, there is no reserve requirement at all. However, here too banks cannot go on creating unlimited money.

This is because the capital adequacy ratio also impacts the amount of credit that can be created by the banks.

Capital adequacy ratios mandate that a certain amount of the deposits be kept aside whenever a loan is being made. These deposits are kept aside as provisions to cover up the losses in case the loan goes bad.

These provisions therefore limit the amount of deposits that can be loaned out and hence limit creation of credit.

Changes to the capital adequacy ratio therefore can have a significant impact on the inflation in the economy.

Credit Exposure

The capital adequacy ratios are laid the credit exposure that a particular bank has. Credit exposure is different from the amount loaned out.

This is because banks can have credit exposure if they hold derivative products, even though they have not actually loaned out any money to anybody.

Therefore, the concept of credit exposure and how to measure it in a standardized way across various banks in different regions of the world is an important issue in formulating capital adequacy ratios. There are two major types of credit exposures that banks have to deal with.

  • Balance Sheet Exposure: Balance sheet exposure is the amount of risk that a bank is exposed to on account of the activities that are listed on its balance sheet. This would include the credit exposure that result from the loans that have been sanctioned. It would also result from the credit exposure that is the result of the securities that have been purchased by the bank. Hence an analyst can simply look at the balance sheet and come to an exact estimate of the credit exposure of any bank.
  • Off Balance Sheet Exposure: On the other hand, there are some risky activities that a bank takes that are not listed on the balance sheet. For instance, bank may issue guarantees to some parties on behalf of some other parties. These guarantees are not financial transactions that can be listed on the balance sheet.
  • However, they do create credit risk in the process. Similarly the bank may purchase derivative products which do not have any effect on the balance sheet today. However, they may expose the bank to significant amounts of risks. The amounts of catastrophic risks that can be caused by derivatives have been witnessed by the banks during the subprime mortgage crisis.

An analyst therefore needs to measure the credit risk that has been generated by off balance sheet activities. In order to accurately calculate the credit exposure that arises due to such risks, the analyst requires additional information from the banks.

Multi-Tiered Capital

For the purpose of calculating the capital adequacy ratio, not all the bank’s capital is considered to be at an equal footing. The capital is considered to have a multi-tiered structure. Therefore, some part of the capital is considered to be more at risk than other parts. These tiers represent the order in which the banks would write off this capital if the situation to do so arises.

Risk Weighting

Also, all credit exposures of the banks are not considered at an equal footing either. Some of the liabilities of the bank i.e. demand liabilities and the loans that have been financed by them are far more dangerous than other liabilities.

Hence, they need to be assigned appropriate risk weights.

Using the system of weighted risks, banks can be more prepared regarding the probability of an adverse outcome and to meet the effects that such an outcome would have on the profitability and solvency of the bank.

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Capital Adequacy

capital adequacy

Financial analysts analyze company performance with different sets of ratios; e.g., earnings per share, return on equity. As a ratio, capital adequacy is just a special solvency ratio, not greatly un the classic debt-to-equity ratio.

But capital adequacy connotes a financial institution’s capital, so it’s really a bank-specific version of the solvency ratio. A firm is insolvent when its debt exceeds its assets, in which case book equity is negative. That’s a balance sheet perspective rather than a cash flow (or income statement) perspective.

Solvency is different than liquidity. A bank is solvent when its assets exceeds its liabilities. Liquidity is effectively a cash-flow perspective: does the bank have high-quality assets (e.g.

, can it sell them quickly?) in order to fund short-term obligations? Solvency does not ensure liquidity: a bank can have valuable assets but an inability to sell them quickly enough to fund immediate obligations.

What is the “capital” in capital adequacy? It is either economic or regulatory capital. Economic capital concerns each bank’s specific and internal perspective on their risk capital. Economic capital is a deep, evolving and important perspective, but I won’t go into here.

The other key perspective is regulatory capital, and to many people, this refers firstly to the Basel rules.

In this way, I think of capital adequacy as a reference to solvency–and to a lesser degree liquidity–ratios that are promulgated by Basel (but just note that “capital adequacy” can also refer to the bank’s internal perspective on the adequacy of its economic capital, or both economic and regulatory capital, as modern banks need to be aware of both). The Basel III regulations look carefully at both solvency and liquidity, with ratio requirements for both. The Basel regulations can be found here.

Isn’t capital just the same as equity which is assets minus liabilities? Nope. The book equity of a modern bank is more or less meaningless.

Bank Capital is Very Difficult to Measure

Before I review the capital adequacy ratios, I want to elaborate on this idea that bank book equity is meaningless. Banks are necessarily fragile and complicated creatures in the economic system. Banking is an industry but banks broker (intermediate) funds between savers (households) and businesses, so they are part of the operating system of the economy.

This brokerage role includes, very importantly, risk transfer. Their unique role implies it will never be easy to measure “capital adequacy.” Why? First, un a non-financial corporation, a bank is always highly leveraged in relative terms. And leverage is fragility. Historically, banks have debt-to-equity ratios of 5.0 or 6.

0 or even greater; so even the equity of a conservative bank is wiped out if assets decline by 15%.

We’ll see below that Basel’s leverage ratio requirement is 3.0%. If that sounds a small number, it surely is. If a bank has a unrealistically simple capital structure of 97.0% debt and 3.0% equity, it meets the 3.0% leverage ratio requirement, but this means that an asset decline of only 3.0% wipes out all the equity!

Second, un many non-financial corporations, the capital structure of a bank itself is incredibly hard to measure, line by line, and therefore in total.

Steve Waldman explains this, albeit philosophically, in a classic post here (including many insightful comments) . Many of the instruments on the bank’s balance sheet are complex: they have ultimately subjective present values.

And then there are the off balance sheet positions which includes derivatives.

It is the nature of derivatives that we cannot easily measure their risk. We explore this deeply in the Financial Risk Manager (FRM).  If a bank invests $10.0 million in a plain old bond, the expected loss and exposure are relatively easy to figure.

If the bank writes a credit default swap instead, to similarly get paid for credit risk, the measurement is more difficult.

An interest rate swap has zero value at inception, but what is its future exposure? Sure it can be answered but it’s more there are several different valid answers. An an honest answer comes with a confidence interval attached.

When we roll all of this up, we get to Steve Waldman’s conclusion. The equity value—at any given point in time–of a large financial institution is up for debate and depends on all of the assumptions.

Basel history: I, II, III

The first Basel Accord (aka, Basel I) was published in 1988. It established the original regulatory ratio of 8.0%, which remained the foundation for years.

This regulatory ratio capital is conceptually simple:

  • Basel I: regulatory capital / Credit risk-weighted assets (RWA) >= 8.0%, or equivalently
  • Basel I: regulatory capital >= 8.0% * Credit risk-weighted assets (RWA)

This is analogous to an equity/asset ratio of at least 8.0%. But instead of book (accounting-based) assets, the assets are adjusted for risk, which turns out to be a difficult and often subjective exercise.

Similarly, regulatory capital is not exactly book equity. Further, in a traditional view, the first accord only included credit risk.

Risk-weighted assets included loans and credit exposures; the key perceived risk was default.

The BIS committee constantly updates the regulations, sometimes slowly. By the time Basel II was introduced, the regulatory ratio had expanded to include market risk and operational risk.

  • Basel II: regulatory capital / [Credit risk + Market risk + Operational risk] >= 8.0%; or equivalently,
  • Basel II: regulatory capital >= (credit RWA * 8.0%) + market risk charge (MRC) + operational risk charge (ORC)
    • Please note: Market Risk = MRC * 12.5 because 1/12.5 equals 0.08. By multiplying MRC and ORC by 12.5, Market Risk and Operational Risk can be conveniently added to Credit Risk, then the sum constitutes the denominator of a ratio that must exceed 8.0%. This is the same as saying that regulatory capital must cover the full MRC and ORC in addition to 8.0% of the Credit risk-weighted assets.

Basel II was lengthy and detailed, but it looked at least comprehensive when it was published in 2004.

It expanded the types of risks covered by regulatory capital and greatly increased the sensitivity of risk measurement (the chief innovation was adding three approaches to each of the major risk buckets, so smaller banks could use a standard off-the-shelf approach while more sophisticated banks could employ their own internal metrics subject to supervision). But the global financial crisis (GFC) proved Basel II to be incomplete.

Basel III is the current rule set. It adds to the complexity of regulatory capital adequacy by supplementing the adequacy ratio I’ve just introduced with two liquidity ratios and a leverage ratio.

Wait a second, isn’t the regulatory capital ratio already a leverage (aka, solvency) ratio? Yes, it really is. But the chief regulatory capital ratio is very sensitive to the approach used.

Basel basically put in a simple, blunt backstop: in addition meeting the primary capital adequacy requirement, a bank also needs to have simple leverage (Tier 1 equity / assets) of at least 3.0%.

But that’s not all. Basel III also further parsed the primary adequacy ratio into several slices. Why? Mostly because not all capital (equity) is equally safe buffer.

Basel III phases in requirements for Core Tier 1 (common equity), Tier 1 and Total (Tier 1 plus Tier 2). But Basel III retains the Basel II ratio. Basically, the ratio of 8.

0% in Basel II maps to the Total Capital (Tier 1 + Tier 2) ratio in Basel III, which I will illustrate below.

Core, Tier 1 and Tier 2

Basel proposed to phase-in the capital adequacy requirement over time. You can see their phase-in calendar here.

As of 2019, when the rules are fully phased in, the following regulatory capital adequacy ratios will apply:

  • Common equity (core Tier) 1 must be 4.5%
  • Tier 1 must be 6.0%
  • Total capital must be 8.0%
  • Leverage ratio must be at least 3.0%

These are the essential capital adequacy ratios. The global financial crisis taught many lessons. One brutal lesson was that liquidity matters in addition to solvency. So Basel III added liquidity ratios. Specifically, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

Illustration of Capital Adequacy Ratios

Let’s look at an illustration to see how the regulatory capital ratios are calculated. Here is a copy of the spreadsheet I built for this example.  Keep in mind this is a simplified illustration that also does not include market and operational risk. Actual risk weights can be more granular than shown.

For example, “Loans to foreign banks” have different risk weights depending on the host country’s risk classification (CRC, country risk classification). Nevertheless, we can appreciate Basel’s intent with even a simple example. Below is the asset side of the balance sheet for a hypothetical bank. This bank has Total Assets of $2,810.0 million.

I also listed off-balance sheet items without specific notional amounts (”$abc”) just to emphasize their existence; but I won’t dive into the lengthy topic of computing their risk-adjusted credit-equivalent value. However, they do need to be included in the total risk-weighted assets.

Notice that each asset is multiplied by its risk-weighting to produce a risk-adjusted value. For example, cash has a weight of zero, so cash does not contribute to a bank’s risk-adjusted assets. In this example, commercial and consumer loans receive 100% weight. Residential mortgage assets with book value of $520.0 million are weighted 50% such that only $260.

0 million accrue to risk-weighted assets (this applies to first liens with loan-to-value of 60% to 80% but the weight can vary from 35% to 100%).

On the asset side (above), we have determined that this hypothetical bank carries $2.810 billion in total assets which translate into risk-weighted assets (RWA) of $2.0 billion. Now consider the bank’s Liabilities and Equity (below). These accounts inform the denominator of the capital adequacy ratios.

We will not assign them weights. Rather, it is a question of buffer quality.

Common stock and retainer earning are buffer of the highest quality, the constitute Common Equity Tier 1 (CET1); minority interest is an example of additional Tier 1 (T1) and convertible bonds are an example of Tier 2 capital:

Now we can compute four of the key capital adequacy ratios (under Basel III in any case!):

The four calculated ratios are:

  • The leverage ratio = CET1/assets = 90/2,810 = 3.20% which exceeds the required 3.0% leverage
  • The common Equity (CET) ratio = CET1/RWA = 90/2,000 = 4.50% which exactly meets the required 4.5% but fails to allocate an additional 2.5% to the capital conservation buffer (CCB)
  • The Tier 1 ratio = Tier 1/RWA = 130/2,000 = 6.50% which exceeds the required 6.0% for Tier 1 capital
  • The Total (Tier 1 + Tier 2) ratio = (Tier 1 + Tier 2)/RWA = 240/2,000 = 12.0% which easily exceeds the 8.0% required for total capital

This hypothetical bank meets or exceeds each of the ratios (i.e., Common equity, Tier 1 and Total Capital) so it has adequate regulatory capital, with the exception of the capital conservation buffer (CCB). Because it has no buffer, it would be required to retain all of its earnings and could not pay out dividends.

Basel also includes two other pillars

The ratios above are the essential capital adequacy rules in Basel III. They are the math in Basel, so to speak. They represent minimum capital requirements in quantitative terms. But capital adequacy is not just a number. The Basel regulations also include two other pillars, Supervisory Review (the Second Pillar) and Market Discipline (the Third Pillar).

They don’t get as much attention but they probably should. The Second Pillar has been called the “load-bearing” pillar. It recognizes the quantitative rules in the first pillar are not a total solution, and it puts the burden on national supervisors to ensure each bank has a process and adequate capital for its unique situation.

It justifies a supervisor insisting that a bank hold more capital than required under the first pillar  (i.e., the first pillar is just a minimum). The Third Pillar attaches various disclosure requirements; it trust the market to evaluate and impose discipline. If banks want to rely on their internal models (e.g.

, if they want to measure market risk with their own value-at-risk, VaR, models rather than standard models), the price is greater disclosure to investors under the third pillar.

Summary

I first meant to engender sympathy for the complicated Basel ratios by reminding you that banks are fragile, complicated creatures (why else would we need so many perspectives!). Then I quickly summarized the evolution from Basel I to the current Basel III (although I spared you the calculation of market risk and operational risk, did you notice?).

Then we looked at the four essential capital adequacy ratios: leverage, common equity Tier 1, Tier 1 and Total Capital. In summary, Basel III will require banks to hold 6.0% in Tier 1 (high-quality equity and equity-) and 8.0% in Total Capital plus a Capital Conservation Buffer of 2.5%. This represents an increase from Basel II’s 8.0% ratio to 10.

5% (along with a tightening in the definition of quality equity).

Источник: https://www.bionicturtle.com/capital-adequacy/

Capital Adequacy Ratio (Definition, Formula) | How to Calculate?

capital adequacy

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.

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 capital 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 assets, 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 assets 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 –

Capital Adequacy Ratio Formula = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets

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,

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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

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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Capital Adequacy Ratio (CAR) — Overview and Example

capital adequacy

The Capital Adequacy Ratio set standards for banksBanking (Sell-Side) CareersThe banks, also known as Dealers or collectively as the Sell-Side, offer a wide range of roles investment banking, equity research, sales & trading by looking at a bank’s ability to pay liabilities, and respond to credit risks and operational risks. A bank that has a good CAR has enough capital to absorb potential losses. Thus, it has less risk of becoming insolventInsolvencyInsolvency refers to the situation in which a firm or individual is unable to meet financial obligations to creditors as debts become due. Insolvency is a state of financial distress, whereas bankruptcy is a legal proceeding. and losing depositors’ money. After the financial crisis in 2008, the Bank of International Settlements (BIS) Bank for International Settlements (BIS)The Bank for International Settlements (BIS) started in 1930, and is owned by the central banks of different countries. It serves as a bank for member central banks, and its role is to foster international monetary, financial stability and financial corporation. The Bank for International Settlements is based inbegan setting stricter CAR requirements to protect depositors.

Quick Summary Points

  • The Capital Adequacy Ratio (CAR) helps makes sure banks have enough capital to protect depositors’ money.
  • The formula for CAR is: (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets
  • Capital requirements set by the BIS have become more strict in recent years.

What is the Capital Adequacy Ratio Formula?

As shown below, the CAR formula is:

CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

The Bank of International Settlements separates capital into Tier 1 and Tier 2 the function and quality of the capital. Tier 1 capital is the primary way to measure a bank’s financial health.

It includes shareholder’s equityOwner’s EquityOwner's Equity is defined as the proportion of the total value of a company’s assets that can be claimed by the owners (sole proprietorship or partnership) and by the shareholders (if it is a corporation).

It is calculated by deducting all liabilities from the total value of an asset (Equity = Assets – Liabilities). and retained earningsRetained EarningsThe Retained Earnings formula represents all accumulated net income netted by all dividends paid to shareholders.

Retained Earnings are part of equity on the balance sheet and represent the portion of the business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment, which are disclosed on financial statements.

As it is the core capital held in reserves, Tier 1 capital is capable of absorbing losses without impacting business operations. On the other hand, Tier 2 capital includes revalued reserves, undisclosed reserves, and hybrid securities. Since this type of capital has lower quality, is less liquid, and is more difficult to measure, it is known as supplementary capital.

The bottom half of the equation is risk-weighted assets. Risk-weighted assets are the sum of a bank’s assets, weighted by risk.

Banks usually have different classes of assets, such as cash, debenturesDebentureA Debenture is an unsecured debt or bonds that repay a specified amount of money plus interest to the bondholders at maturity.

A debenture is a long-term debt instrument issued by corporations and governments to secure fresh funds or capital. Coupons or interest rates are offered as compensation to the lender., and bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital.

The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period., and each class of asset is associated with a different level of risk. Risk weighting is decided the lihood of an asset to decrease in value.

Asset classes that are safe, such as government debt, have a risk weighting close to 0%. Other assets backed by little or no collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan.

It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments., such as a debenture, have a higher risk weighting. This is because there is a higher lihood the bank may not be able to collect the loan. Different risk weighting can also be applied to the same asset class.

For example, if a bank has lent money to three different companies, the loans can have different risk weighting the ability of each company to pay back its loan.

Calculating the Capital Adequacy Ratio (CAR) – Worked Example

Let us look at an example of Bank A. Below is the information of the Bank A’s Tier 1 and 2 Capital, and the risks associated with their assets.

Bank A has three types of assets: Debenture, Mortgage, and Loan to the Government. To calculate the risk-weighted assets, the first step is to multiply the amount of each asset by the corresponding risk weighting:

  • Debenture: $9,000 * 90% = $8,100
  • Mortgage:  $45,000 * 75% = $33,750
  • Loan to Government: $4,000 * 0% = $0

As the loan to the government carries no risk, it contributes $0 to the risk-weighted assets.

The second step is to add the risk-weighted assets to arrive at the total:

  • Risk-Weighted Assets: $8,100 + $33,750 + $0 = $41,850

The calculation can be easily done on Excel using the SUMPRODUCTSUMPRODUCTThe SUMPRODUCT Function is categorized under Excel Math and Trigonometry functions. The function will multiply the corresponding components of a given array and then return the sum of the products. SUMPRODUCT is a very handy formula as it can handle arrays in different ways and help in comparing data function.

To learn more about Excel functions, take a look at CFI’s free Excel course.

The Capital Adequacy Ratio of Bank A is as follows :

Where:

  • CAR : $4,000 / $41,850 = 10%

As Bank A has a CAR of 10%, it has enough capital to cushion potential losses and protect depositors’ money.

What are the Requirements?

Under Basel IIIBasel IIIThe Basel III accord is a set of financial reforms that was developed by the Basel Committee on Banking Supervision (BCBS), with the aim of strengthening, all banks are required to have a Capital Adequacy Ratio of at least 8%. Since Tier 1 Capital is more important, banks are also required to have a minimum amount of this type of capital. Under Basel III, Tier 1 Capital divided by Risk-Weighted Assets needs to be at least 6%.

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™FMVA® CertificationJoin 350,600+ students who work for companies Amazon, J.P. Morgan, and Ferrari certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Bank Run Bank RunA bank run occurs when customers withdraw all their money simultaneously from their deposit accounts with a banking institution for fear that the bank
  • Financial Statement for BanksFinancial Statements for BanksFinancial Statements for Banks differ from those of non-banks in that banks use much more leverage than other businesses and earn a spread (interest) between loans and deposits. This guide will discuss the balance sheet and income statement line items most banks have, along with examples of how they work
  • Financial Intermediary Financial IntermediaryA financial intermediary refers to an institution that acts as a middleman between two parties in order to facilitate a financial transaction. The institutions that are commonly referred to as financial intermediaries include commercial banks, investment banks, mutual funds, and pension funds.
  • Capital Adequacy Ratio Calculator

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Capital Adequacy Ratio | Step by Step calculation of CAR with Advantages

capital adequacy

In the banking system, the term “capital adequacy ratio” refers to the assessment of the bank capital to be maintained corresponding to the risk-weighted credit exposures. The capital adequacy ratio is also known as capital to risk-weighted assets ratio.

The ratio was introduced with the objective to protect the bank depositors by promoting stability and efficiency in the banking systems across the world.

The ratio is decided by the central banks for the respective countries ( the Federal Reserve for the United States of America) in order to prevent the commercial banks from indulging in exorbitantly high leverage that may eventually result in its insolvency.

The CAR truly kicked in after the financial crisis in 2008 when the Bank of International Settlements (BIS) decided to introduce some restrictions and requirements for the banks to protect the depositors.

In the ideal scenario, a financial institution is expected to have a CAR higher than the threshold limit which indicates that it has a sufficient amount of capital to withstand any unexpected losses during times of economic downturns. On the other hand, a low CAR indicates that the financial institution is at a higher risk of failure during any economic disruption.

Formula

The formula for capital adequacy ratio can be derived by dividing the sum of Tier I and Tier II capital maintained by the subject bank by its risk-weighted assets. Mathematically, it is represented as,

Capital Adequacy Ratio = (Tier I Capital + Tier II Capital) / Risk-Weighted Assets

The Tier 1 capital in the numerator primarily includes ordinary share capital, intangible assets, future tax benefits, audited revenue reserves, etc.

, while Tier II capital includes unaudited retained earnings, revaluation reserves, general provisions for bad debts, perpetual cumulative preference shares, perpetual subordinated debt, subordinated debt, etc.

Risk-weighted assets, on the other hand, involves a very complex method of evaluating a bank’s loan book to determine its credit risk, market risk and operational risk which ultimately gives the risk-weighted assets.

Examples of Capital Adequacy Ratio (With Excel Template)

Let’s take an example to understand the calculation of the Capital Adequacy Ratio formula in a better manner.

Example – #1

Let us take the example of a bank for which the following information pertaining to its risk capital and loan book is available:

the given information, calculate the capital adequacy ratio for the bank and check if it complies with the minimum requirement of 10%.

Solution:

Risk-Weighted Assets is calculated as

  • Risk-Weighted Assets   = $10.00 Mn * 90% + $50.00 Mn * 60% + $5.00 Mn * 0%
  • Risk-Weighted Assets = $39.00 Mn

Capital Adequacy Ratio is calculated by using the formula given below

Capital Adequacy Ratio = (Tier I Capital + Tier II Capital) / Risk-Weighted Assets

  • CAR = ($3.00 Mn + $1.00 Mn) / $39.00 Mn
  • CAR = 10.3%

Therefore, the bank satisfies the minimum requirement of 10% set by the regulatory bodies.

Example – #2

Let us now take the example of Bank of America to calculate the capital adequacy ratio. According to the annual report for the year 2018, the following information is available (under advanced approach):

the given information, calculate the capital adequacy ratio of Bank of America for the year 2018.

Solution:

Tier I Capital is calculated as

Tier I Capital = Common Equity Tier I Capital + Qualifying Preferred Stock + Other Tier I Capital

  • Tier I Capital = $167.27 Bn + $22.33 Bn + ($0.56 Bn)
  • Tier I Capital = $189.04 Bn

Tier II Capital is calculated as

Tier II Capital = Tier II Capital Instruments + Eligible Credit Reserves Included in Tier-II Capital + Other Tier II Capital

  • Tier II capital = $21.89 Bn + $1.97 Bn + ($0.02 Bn)
  • Tier II capital = $23.84 Bn

Now, the capital adequacy ratio for Bank of America can be calculated by using the above formula as,

Capital Adequacy Ratio = (Tier I Capital + Tier II Capital) / Risk-Weighted Assets

  • CAR = ($189.04 Bn + $23.84 Bn) / $1,409 Bn
  • CAR = 15.1%

Therefore, the capital adequacy of the Bank of America stood at 15.1% for the year 2018 under the advanced approach.

Link: media.corporate-ir.net

Advantages and Disadvantages of Capital Adequacy Ratio

Some of the advantages and disadvantages of CAR are as follows:

Advantages

  • It helps the banks to maintain capital the riskiness of each loan exposure.

    For instance, two banks with the same loan book size but a different level of portfolio risk will be required to maintain corresponding bank capital. Higher the risk, the higher the capital required.

  • The ratio is a good indicator for the investors to understand the overall risk of the loan book of a bank.

Disadvantages

One major limitation of capital adequacy ratio is that it is unable to account for the expected losses that can deform a bank’s capital during any financial crisis.

Conclusion

So, the capital adequacy ratio is a risk measure for the commercial banks that helps the regulatory bodies to keep a close track of the risk level of bank lending.

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