Capital Adequacy Ratio is the ratio that determines the capacity of the bank to meet time liabilities or other risks including operational risk, credit risk, etc. This measures the amount of the bank’s capital that is expressed through percentage of the bank’s risk credit exposures.
For a simple formulation, the capital of the bank is considered as the cushion for any potential loses. This is created to be able to protect the lenders and depositors.
The banking regulators for most of the countries monitor and defines Capital Adequacy ratio to give protection to the depositors.
It also maintains the confidentiality of the bank system. A particular International standard that recommends a minimum Capital Adequacy Ratio has been developed to make sure that the bank can absorb a reasonable level of certain loss before it becomes insolvent.
This protects depositors and promotes stability as well as financial system efficiency.
There are 2 types of capital that is being recognized by the Basil rules. This recognizes that the different types of equity are very much important than the others.
Tier 1 capital – It absorbs the losses without requiring the bank to cease trading. The ordinary share capitals are considered as an example for this. This is also the actual-contributed equity and the additional is the retained earnings.
Tier 2 capital – It absorbs the losses in the particular event which is the winding up and it provides a lesser degree of a protection to the depositors. Subordinated debt is one of the examples of this. Prepared shares and additional fifty percent of subordinated debt are also examples for this type.
Capital Adequacy Ratio is being applied with a minimum of Tier 1 equity of 4% risk-weighted assets while the other minimum CAR includes Tier II with 8%. Measuring credit exposure also requires adjustments and this is done to know the amount of assets that are shown on the balance sheet of the bank.
Banks that provide loans are being weighed in a broad manner and usually on their degree of risk. For instance, loans to the governments are given 0% of weighing and loans for every individual have 100% weighting.
The contracts of off-balance sheet like foreign exchange contract, guarantees, credit risks are being converted to the amounts of credit equivalent which are weighed the same just like exposures of an on-balance sheet. Off- balance sheets and on-balance sheets credit exposures are added to get the total risk of weighted-credit exposures.
Capital Adequacy ratio is very important. This is considered as a key part of the bank’s regulation. This is used to make sure that firms that operating in the bank industry can be managed carefully.
Aiming to protect the customer, the economy and the firm is something that helps gain the trust of the customers.
Establishing useful as well as effective rules will surely make the institution hold the capital properly and ensure the continuous safety of the firms and also keep an efficient market all the time.
This also helps the bank to withstand any possible or unforeseeable problems.