What is Capital Adequacy Ratio (CAR)?
Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital (tier 1, tier 2) and its risk(weighted). Thus, it is also known as Capital to Risk-Weighted-Assets Ratio (CRAR).
It determines the level of capital with the bank in relation to the exposure risk and is monitored by the bank and the central bank to gauge the performance of the bank with respect to the credit risk. So, having this ratio high is preferred from a regulatory point of view.
This is done to prevent banks from defaulting credits, assets which may cause dominos-effect harm to the whole financial system and even the economy if not regulated continuously.
Formula of CAR:
Capital Adequacy Ratio (CAR) = (Tier 1 Capital + Tier 2 Capital) / (Risk-weighted Assets)
where,
Tier 1 Capital = Bank’s reserves, share capital, revenue reserves, intangible assets, tax benefits
Tier 2 Capital = Revaluation reserves, Unaudited revenues, Subordinated debts, Reserves for Bad Debt
Risk-Weighted assets include the capital, assets that the bank holds to prevent insolvency, It includes various assets classified based on their quality and risk of default.
Prescribed CAR
By Basel III norms: CAR of 8%
By RBI norms:
Scheduled commercial banks- CAR of 9%
Indian public sector banks- CAR of 12%
The Capital Adequacy Ratio of State Bank of India was around 13% in March 2020. Generally, in India, major private banks have better CAR at around 20%.
Overall CAR of major banks in India over the last decade is as shown below:
In case CRAR(CAR) of a bank falls below prescribed level, regulatory bodies and government act upon it along with bank management to improve it.
One of the ways to increase CAR is as done by the Cabinet Committee on Economic Affairs with Regional Rural Banks (RRBs) in India.
CCEA approved providing certain capital to RRBs which were unable to maintain a CAR of 9% to subsequently strengthen not just RRBs but the whole lending ecosystem for micro and small enterprises in rural areas of India.