Capital Adequacy Ratio (CAR)

Definition and purpose

The Capital Adequacy Ratio (CAR), also called the capital-to-risk weighted assets ratio (CRAR), measures a bank’s available capital as a proportion of its risk-weighted assets (RWA). Regulators use CAR to assess a bank’s capacity to absorb losses and protect depositors, helping to preserve financial stability.

How CAR is calculated

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

• Tier 1 capital (core capital): common equity (share capital, retained earnings, accumulated other comprehensive income) and certain disclosed reserves. It is the primary loss-absorbing capital.
• Additional Tier 1 (AT1): perpetual instruments and hybrid securities that can absorb losses without forcing the bank to stop operating (e.g., discretionary coupons).
• Tier 2 capital: subordinate long-term debt and other instruments that can absorb losses in a gone‑concern scenario (often with maturities > 5 years or convertible features).

Risk-weighted assets
– RWAs adjust each asset by a risk weight reflecting credit, market, and operational risks. Safer assets receive lower weights (e.g., some sovereign exposures can be 0%), while riskier loans can be weighted up to 100% or more.
– Off‑balance-sheet items (guarantees, undrawn facilities, derivatives) are converted to credit-equivalent amounts and included in RWAs.

Basel minimum requirements
– Common Equity Tier 1 (CET1) ≥ 4.5% of RWA
– Tier 1 capital ≥ 6.0% of RWA
– Total capital (Tier 1 + Tier 2) ≥ 8.0% of RWA

These are minimum regulatory floors; many jurisdictions and regulators require higher buffers (capital conservation buffers, countercyclical buffers, systemic surcharges).

Simple example

If a bank has:
– Tier 1 capital = $20 million
– Tier 2 capital = $5 million
– Risk-weighted assets = $65 million

Then CAR = (20 + 5) / 65 = 0.3846 → 38.5%. A high CAR indicates a sizeable cushion to absorb loan losses and withstand stress.

Why CAR matters

• Indicates whether a bank has enough loss-absorbing capital relative to the riskiness of its assets.
• Helps regulators identify undercapitalized banks and run stress tests.
• Supports depositor protection: higher CAR generally means lower probability that losses will erode depositor funds.

Comparisons with related ratios

• CAR vs. Solvency Ratio: CAR is bank-specific and risk-weighted; the solvency ratio (used across industries) measures a company’s ability to meet long- and short-term obligations often based on cashflow. Solvency ratios focus more on liquidity and available cash than on regulatory capital adequacy.
• CAR vs. Tier‑1 Leverage Ratio: The Tier‑1 leverage ratio = Tier‑1 capital / (average total consolidated assets + certain off‑balance exposures). It is a non-risk-weighted backstop to CAR that limits leverage regardless of asset risk weights.

Limitations and alternatives

• CAR relies on risk weights and accounting measures that can understate true risk (model risk, regulatory arbitrage).
• It does not capture liquidity risk or the dynamics of a bank run—high CAR does not immunize a bank from rapid funding shocks.
• Off‑balance-sheet exposures and mark‑to‑market losses can alter risk quickly.
• Economic capital (an internal, bank-specific measure based on expected losses, confidence levels, and stress scenarios) is often viewed by banks as a more realistic gauge of capital needs because it incorporates expected losses and firm-specific risk profiles.

Key takeaways

• CAR = (Tier 1 + Tier 2) / RWA and is a primary regulatory metric for bank solvency.
• Basel minimums require CET1 ≥ 4.5%, Tier 1 ≥ 6%, and total capital ≥ 8% of RWA (with many jurisdictions imposing higher buffers).
• A higher CAR generally signals greater ability to absorb losses; it should be considered alongside liquidity metrics, leverage ratios, and economic capital assessments for a fuller picture of bank health.