Capital Adequacy Ratio (CAR): Definition and Formula

A bank’s ability to withstand financial shocks and maintain its operations is measured by the capital adequacy ratio (CAR). This ratio is calculated by dividing a bank’s available capital by its risk-weighted credit exposures and expressing the result as a percentage.

The CAR is a crucial metric for banks because it indicates their ability to absorb losses and remain solvent. Banks with higher CARs are considered more financially stable and less likely to fail during economic downturns or other crises.

The CAR is calculated using a complex formula that takes into account various factors, including the type of assets held by the bank, the level of risk associated with those assets, and the amount of capital held by the bank. The formula is designed to ensure that banks maintain sufficient capital to cover potential losses while still being able to lend money and generate profits.

The CAR is typically expressed as a percentage, with higher percentages indicating a stronger financial position. In general, regulators require banks to maintain a minimum CAR of 8%, although some countries may have higher or lower requirements.

Banks that fall below the minimum CAR may be subject to regulatory action, such as restrictions on lending or requirements to raise additional capital. In extreme cases, banks may be forced to close or merge with other institutions in order to maintain their solvency.

The CAR is not the only measure of a bank’s financial health, but it is one of the most important. Other metrics, such as the leverage ratio and the liquidity ratio, also play a role in assessing a bank’s stability and ability to withstand financial shocks.

Overall, the capital adequacy ratio is a critical tool for regulators, investors, and analysts who need to assess the financial health of banks. By measuring a bank’s available capital in relation to its risk-weighted credit exposures, the CAR provides valuable insights into a bank’s ability to weather economic storms and remain solvent over the long term.