Capital Adequacy Ratio (CAR)

Capital Adequacy
Amount of capital relative to a financial institution's loans and other assets. Almost all banking
regulators require that banks hold a certain minimum of equity capital against their risk-weighted
assets. The Basel Committee on Bank Supervision, a coordinating body within the Bank for
International Settlements, supervises the administration of capital reserves for central bankers.

Investopedia Says:
This ratio is used to protect depositors and promote the stability and efficiency of financial
systems around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank
being required to cease trading, and tier two capital, which can absorb losses in the event of a
winding-up and so provides a lesser degree of protection to depositors.

Formula
Capital adequacy ratios ("CAR") are a measure of the amount of a bank's core capital expressed
as a percentage of its risk-weighted asset.
Capital adequacy ratio is defined as

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TIER 1 CAPITAL - (paid up capital + statutory reserves + disclosed free reserves) - (equity
investments in subsidiary + intangible assets + current & b/f losses)
TIER 2 CAPITAL -A) Undisclosed Reserves, B) General Loss reserves, C) hybrid debt capital
instruments and subordinated debts
where Risk can either be weighted assets ( ) or the respective national regulator's minimum total
capital requirement. If using risk weighted assets,

10%.
The percent threshold varies from bank to bank (10% in this case, a common requirement for
regulators conforming to the Basel Accords) is set by the national banking regulator of different
countries.

Two types of capital are measured: tier one capital (

above), which can

absorb losses without a bank being required to cease trading, and tier two capital ( above),
which can absorb losses in the event of a winding-up and so provides a lesser degree of
protection to depositors.

Use
Capital adequacy ratio is the ratio which determines the bank's capacity to meet the time
liabilities and other risks such as credit risk, operational risk, etc. In the most simple formulation,
a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other
lenders. Banking regulators in most countries define and monitor CAR to protect depositors,
thereby maintaining confidence in the banking system.[1]
CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debtto-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity;
since assets are by definition equal to debt plus equity, a transformation is required). Unlike
traditional leverage, however, CAR recognizes that assets can have different levels of risk.

Risk weighting
Since different types of assets have different risk profiles, CAR primarily adjusts for assets that
are less risky by allowing banks to "discount" lower-risk assets. 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.
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Risk weighting example

Risk weighted assets - Fund Based: Risk weighted assets mean fund based assets such as cash,
loans, investments and other assets. Degrees of credit risk expressed as percentage weights have
been assigned by RBI to each such assets.
Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance sheet
items has to be first calculated by multiplying the face amount of each of the off-balance sheet
items by the Credit Conversion Factor. This will then have to be again multiplied by the relevant
weightage. Local regulations establish that cash and government bonds have a 0% risk
weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets
(loans to customers) have a 100% risk weighting.
Bank "A" has assets totaling 100 units, consisting of:

Cash: 10 units
Government bonds: 15 units
Mortgage loans: 20 units
Other loans: 50 units
Other assets: 5 units

Bank "A" has debt of 95 units, all of which are deposits. By definition, equity is equal to assets
minus debt, or 5 units. Bank A's risk-weighted assets are calculated as

follows:
Cash
Government securities
Mortgage loans
Other loans
Other assets

Total risk-weighted assets = ========== 65%

Equity

CAR==== (Equity/RWA) 7.69%

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Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or
equity-to-assets of only 5%, its CAR is substantially higher. It is considered less
risky because some of its assets are less risky than others.

Types of capital
The Basel rules recognize that different types of equity are more important than
others. To recognize this, different adjustments are made:
1. Tier I Capital: Actual contributed equity plus retained earnings.
2. Tier II Capital: Preferred shares plus 50% of subordinated debt.
Different minimum CAR ratios are applied: minimum Tier I equity to riskweighted assets may be 4%, while minimum CAR including Tier II capital may be
8%.

There is usually a maximum of Tier II capital that may be

"counted" towards CAR, depending on the jurisdiction.

Liquidity Ratios
Key financial ratios measuring a bank's application of
interest-earning deposit liabilities to fund loan growth,
expressed as a percentage. There are four primary liquidity
ratios: cash and unpledged marketable securities divided by
total assets; total deposits divided by borrowed funds; volatile
funds divided by liquid assets; and total loans divided by total
deposits (most commonly used). A low ratio of loans to deposits
indicates excess liquidity, and potentially low profits, compared
to other banks. A high loan-to-deposit ratio presents the risk
that some loans may have to be sold at a loss to meet
depositors' claims.

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Subordinated debt
In finance, subordinated debt (also known as subordinated loan, subordinated
bond, subordinated debenture or junior debt) is debt which ranks after other
debts should a company fall into liquidation or bankruptcy.
Such debt is referred to as subordinate, because the debt providers (the lenders)
have subordinate status in relationship to the normal debt. A typical example for
this would be when a promoter of a company invests money in the form of debt,
rather than in the form of stock. In the case of liquidation (e.g. the company winds
up its affairs and dissolves) the promoter would be paid just before stockholders
assuming there are assets to distribute after all other liabilities and debts have been
paid.
Subordinated debt has a lower priority than other bonds of the issuer in case of
liquidation during bankruptcy; below the liquidator, government tax authorities
and senior debt holders in the hierarchy of creditors. Because subordinated debt is
repayable after other debts have been paid, they are more risky for the lender of the
money. It is unsecured and has lesser priority than that of an additional debt claim
on the same asset.
Subordinated loans typically have a lower credit rating, and therefore a higher
yield, than senior debt. While subordinated debt may be issued in a public
offering, frequently, major shareholders and parent companies are the buyers of
subordinated loans. These entities may prefer to inject capital in the form of
debt, but due to the close relationship to the issuing company they may be more
willing to accept a lower rate of return on subordinated debt than general
investors would.
A particularly important example of subordinated bonds can be found in bonds
issued by banks. Subordinated debt is issued periodically by most large banking
corporations in the U.S. Subordinated debt can be expected to be especially risksensitive, because subordinated debt holders have claims on bank assets after
senior debt holders and they lack the upside gain enjoyed by shareholders. This
status of subordinated debt makes it perfect for experimenting with the significance
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of market discipline, via the signalling effect of secondary market prices of

subordinated debt (and, where relevant, the issue price of these bonds initially in
the primary markets). From the perspective of policy-makers and regulators, the
potential benefit from having banks issue subordinated debt is that the markets and
their information-generating capabilities are enrolled in the "supervision" of the
financial condition of the banks. This hopefully creates both an early-warning
system, like the so-called "canary in the mine," and also an incentive for bank
management to act prudently, thus helping to offset the moral hazard that can
otherwise exist, especially if banks have limited equity and deposits are insured.
This role of subordinated debt has attracted increasing attention from policy
analysts in recent years.[1]
For a second example of subordinated debt, consider asset-backed securities. These
are often issued in tranches. The senior tranches get paid back first, the
subordinated tranches later. Finally, mezzanine debt is another example of
subordinated debt.
Subordinated bonds are regularly issued (as mentioned earlier) as part of the
securitization of debt, such as asset-backed securities, collateralized mortgage
obligations or collateralized debt obligations. Corporate issuers tend to prefer not
to issue subordinated bonds because of the higher interest rate required to
compensate for the higher risk, but may be forced to do so if indentures on earlier
issues mandate their status as senior bonds. Also, subordinated debt may be
combined with preferred stock to create so called monthly income preferred stock,
a hybrid security paying dividends for the lender and funded as interest expense by
the issuer.

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