Capital Adequacy Ratio Wiki



For solving the query of a student, I had opened the wikipedia's page relating to Capital adequacy ratio. I happy to see the above notice in which Wikipedia has mentioned

"This article may be confusing or unclear to readers. Please help clarify the article; suggestions may be found on the talk page."

Wikipedia always not only explains deeply but also informs the limitation of contents. So, here, I am trying to explain what I understood by studying Wikipedia's content and  the other reference on the web :

Introduction of Capital Adequacy Ratio

Wikipedia puts capital adequacy ratio content under financial ratios and financial economics. It propounds the relationship of banks capital with bank's risk. If you had read all the contents of finance, you read the topics under risk management and one topic is Basel Accord. This ratio is also communicate the technique of risk management.

Definition of Capital Adequacy Ratio

Capital adequacy ratio shows the relationship of bank's capital and bank's assets. If we divide bank's capital with bank's assets, then we gets the answer of capital adequacy ratio. Definition of banks risk weighted assets and banks capital have different meaning which will define after its formula

Capital Adequacy Ratio  (CAR)= Bank's Capital / Bank's Risk Weighted Assets

{A} Bank's capital =  For calculation of Capital Adequacy Ratio, we need bank's capital and bank's capital is total of tier 1 capital and tier 2 capital.

(*) Tier 1 Capital = Disclosed Shares/stock/ paid up capital + Disclosed Reserves + Non redeemable and non cumulative preferred shares/ stock

(*) Tier 2 Capital = Undisclosed Reserves + Revaluation reserves + General provisions + Hybrid instruments + Subordinated term debt

{B} Bank's Risk weighted Assets = Bank's different investment will include in banks assets but it will be based on the weight of risk of loss. Suppose bank has the asset of $ 100 and if $ 50 is invested in unsecured loan form, then if bank has given the weight of risk to this asset is 100%, then we calculate risk of asset  as $ 50. Like this bank will give the weight of risk and calculate all the risk weighted assets. Suppose, if bank invests in govt. security and it is risk free and it will be show as zero risk weight of assets of bank. Suppose Bank's capital is 5 and bank's risk weighted assets is 75$ out of $ 100

We can calculate CAR = 5 / 75 X 100 = 6.6 %

Importance of Capital Adequacy Ratio

1st #  CAR  is helpful to check the strengthen the soundness and stability of the banking system.

2nd # This ratio shows unbiased  due to RBI has fixed the %  of Tier I Capital  and Tier II capital

{Tier I Capital should at no point of time be less than 50% of the total capital. This implies that Tier II cannot be more than 50% of the total capital. }

3rd # It is helpful to determine the capacity of the bank to pay  liabilities on the time.

4th # This ratio also indicate the capacity of bank to suffer credit risk, operational risk, etc.

5th # Monitor CAR is helpful to protect depositors.

The Recommendations of Narasimham Committee on Capital Adequacy Measures with particular reference to commercial Banks:

Government of India set up the Narasimham committee to review the functioning of entire financial services industry in the country. Based on the recommendations of the committee (submitted in November 1991), the RBI initiated major reform/liberalization measures that sought to improve bank efficiency through entry deregulation, branch delicensing and deregulation of interest rates and to allow the public sector banks to raise up their equity in the capital market.

"This committee also recommended strengthening of banking system through the BIS norm of 8% capital adequacy ratio, income recognition, assets classifications, etc."

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