Capital Adequacy Ratio (CAR)
Candlefocus EditorCAR is the ratio of a bank's capital to its total risk-weighted assets. It is measured by dividing the bank’s Tier 1 and Tier 2 capital by its total risk-weighted assets. Banks must have enough capital to absorb a reasonable amount of losses without collapsing, so CAR is an important measure for regulators to evaluate the bank’s financial strength.
CAR is mainly used to conduct stress tests to determine whether a bank has sufficient capital to absorb losses from a turbulent economic environment. It is also used by regulators to determine whether the bank's capital adequacy is sufficient.
Regulators view two types of capital when assessing the adequacy of a bank's capital. Tier-1 capital is considered the most important safety cushion that can absorb losses before the bank has to stop its trading activities. Tier-2 capital can sustain losses if there's a liquidation.
The major downside of using the CAR as a measure of a bank’s adequacy is that it does not account for the risk of a potential run on the bank or what could happen in a financial crisis. Moreover, CAR is based on historical data and current regulations, which may not be sufficient to measure an institution’s capacity to deal with unforeseen events.
It is important to take into consideration that CAR is not the only measure of a bank’s financial health. Regulators must also consider other factors such as profitability, liquidity, and quality of the bank’s assets. These measures, in combination with CAR, can help to provide a more complete picture of a bank’s financial strength.
In conclusion, Capital Adequacy Ratio is a key measure used by regulators to determine a bank’s financial strength and ability to absorb losses under unforeseen circumstances. The ratio has both its limitations, as well its strengths. While it provides an initial indication of capital adequacy, it is only one of several elements required in determining the overall financial health of a bank.