Tier 1 capital is the common equity and disclosed reserves of the company. Tier 2 capital consists of subordinate debt, hybrid instruments, revaluation reserves etc. Subordinate debt is debt that has secondary claim to other debt in case the banking company goes bankrupt.

CAR minimums are 8.0% under Basel II and 10.5% (with an added 2.5% conservation buffer) under Basel III. The higher the CAR, the what is car in banking better able a bank should be to meet its financial obligations when under stress. The Capital Adequacy Ratio (CAR) is a measure that shows the amount of capital a bank holds in relation to its risk-weighted assets. It ensures that banks have enough capital to absorb potential losses and avoid insolvency. This sums up the definition of the capital adequacy ratio, the capital adequacy ratio formula and why the CAR is important.

Risk weighting

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For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%. For example, the minimum Tier I equity allowed by statute for risk-weighted assets may be 6%, while the minimum CAR when including Tier II capital may be 8%. Under Basel III, all banks are required to have a Capital Adequacy Ratio of at least 8%.

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Regulatory compliance focus

The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% “risk weighting” – that is, they are subtracted from total assets for purposes of calculating the CAR. The Bank of International Settlements separates capital into Tier 1 and Tier 2 based on the function and quality of the capital. Tier 1 capital is the primary way to measure a bank’s financial health.

1. Under RBI’s current guidelines, public sector banks should have a CAR of at least 12%.
2. The tier-1 capital of a banking institution, also known as core capital, can absorb losses without stopping financial activities.
3. Such exposures are converted to their credit equivalent figures and then weighted in a similar fashion to that of on-balance sheet credit exposures.
4. You can efile income tax return on your income from salary, house property, capital gains, business & profession and income from other sources.
5. These assets are adjusted according to the risk that they carry using an appropriate weightage factor set by the RBI.
6. The capital adequacy ratio is computed by dividing the total capital of a bank by its risk-weighted assets.

However, the capital adequacy ratio is applied specifically to banks and measures their abilities to overcome financial losses related to loans they’ve made. The solvency ratio debt evaluation metric is used to measure whether a company has enough available cash to meet its own short- and long-term debt obligations. Solvency ratios below 20% indicate an increased likelihood of default.

Tier I capital of a bank denotes the share capital and disclosed reserves. It is a bank’s highest quality capital because it is fully available to cover losses. On the other hand, Tier II capital consists of certain types of subordinated debt and reserves.

Solvency ratio:

The Committee weighs in on regulations that concern a bank’s capital risk, market risk, and operational risk. The purpose of the agreements is to ensure that banks (and other financial institutions) always have enough capital to deal with unexpected losses. Off-balance sheet agreements, such as foreign exchange contracts and guarantees, also have credit risks. Such exposures are converted to their credit equivalent figures and then weighted in a similar fashion to that of on-balance sheet credit exposures. The off-balance sheet and on-balance sheet credit exposures are then added together to obtain the total risk-weighted credit exposures. Capital adequacy ratios (CARs) are a measure of the amount of a bank’s core capital expressed as a percentage of its risk-weighted asset.

As the loan to the government carries no risk, it contributes $0 to the risk-weighted assets. Banks hold different types of assets, each with varying degrees of risk. These assets are adjusted according to the risk that they carry using an appropriate weightage factor set by the RBI. However, such capital should be capable of being converted into permanent capital. As an example, the Indian Bank recorded a CAR of 12.55% in 2018, falling from 13.64% in 2017.

Central banks can have risk weight- asset guidelines for their respective countries, based on BIS guidelines. An example of risk weighting of assets is that in case of government bonds that have a credit rating of AAA to AA-, risk weight of 20% should be assigned. Suppose a bank has Rs 100 worth of government bonds on its balance sheet.

Capital Adequacy Ratio (CAR) also known as Capital to Risk (Weighted) Assets Ratio (CRAR),[1] is the ratio of a bank’s capital to its risk. National regulators track a bank’s CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements. As Bank A has a CAR of 10%, it has enough capital to cushion potential losses and protect depositors’ money.

After the financial crisis in 2008, the Bank of International Settlements (BIS) began setting stricter CAR requirements to protect depositors. 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%. The guidelines regarding the risk weights that have to be assigned to the different types of loans are given by Bank of International Settlements (BIS).

It includes shareholder’s equity and retained earnings, which are disclosed on financial statements. Capital Adequacy Ratio (CAR) is a measure of financial strength of a bank expressed as percentage ratio of a bank’s capital to its assets or risks. CAR provides a detailed, risk-sensitive measure, whereas the Tier-1 Leverage Ratio offers a simpler, more direct assessment of leverage. They perform various functions like facilitating liquidity in the economy, ensuring access to funds via loans and securing the capital of depositors. So, if a bank becomes insolvent, it affects a wide range of stakeholders.