Capital Adequacy Ratio (CAR)

Capital AdequacyAmount of capital relative to a financial institution's loans and other assets. Almost all banking regulators require that banks hold a certain minimum of equity capital against their risk-weighted assets. The Basel Committee on Bank Supervision, a coordinating body within the Bank for International Settlements, supervises the administration of capital reserves for central bankers.

Investopedia Says:This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.

Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

FormulaCapital adequacy ratios ("CAR") are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset.

Capital adequacy ratio is defined as

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TIER 1 CAPITAL - (paid up capital + statutory reserves + disclosed free reserves) - (equity investments in subsidiary + intangible assets + current & b/f losses)

TIER 2 CAPITAL -A) Undisclosed Reserves, B) General Loss reserves, C) hybrid debt capital instruments and subordinated debts

where Risk can either be weighted assets ( ) or the respective national regulator's minimum total capital requirement. If using risk weighted assets,

≥ 10%.

The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator of different countries.

Two types of capital are measured: tier one capital ( above), which can absorb losses without a bank being required to cease trading, and tier two capital ( above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

UseCapital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities and other risks such as credit risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.[1]

CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk.

Risk weightingSince different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR.

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Risk weighting example

Risk weighted assets - Fund Based: Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets.

Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the Credit Conversion Factor. This will then have to be again multiplied by the relevant weightage. Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting.

Bank "A" has assets totaling 100 units, consisting of:

Cash : 10 units Government bonds : 15 units Mortgage loans : 20 units Other loans: 50 units Other assets: 5 units

Bank "A" has debt of 95 units, all of which are deposits. By definition, equity is equal to assets minus debt, or 5 units. Bank A's risk-weighted assets are calculated as follows:

Cash

Government securities

Mortgage loans

Other loans

Other assets

Total risk-weighted assets = ========== 65%

Equity 5

CAR==== (Equity/RWA) 7.69%

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Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equity-to-assets of only 5%, its CAR is substantially higher. It is considered less risky because some of its assets are less risky than others.

Types of capitalThe Basel rules recognize that different types of equity are more important than others. To recognize this, different adjustments are made:

1. Tier I Capital: Actual contributed equity plus retained earnings.2. Tier II Capital: Preferred shares plus 50% of subordinated debt.

Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets may be 4%, while minimum CAR including Tier II capital may be 8%.

There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the jurisdiction.

Liquidity Ratios Key financial ratios measuring a bank's application of interest-earning deposit liabilities to fund loan growth, expressed as a percentage. There are four primary liquidity ratios: cash and unpledged marketable securities divided by total assets; total deposits divided by borrowed funds; volatile funds divided by liquid assets; and total loans divided by total deposits (most commonly used). A low ratio of loans to deposits indicates excess liquidity, and potentially low profits, compared to other banks. A high loan-to-deposit ratio presents the risk that some loans may have to be sold at a loss to meet depositors' claims .

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Subordinated debtIn finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts should a company fall into liquidation or bankruptcy.

Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt, rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves) the promoter would be paid just before stockholders—assuming there are assets to distribute after all other liabilities and debts have been paid.

Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy; below the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset.

Subordinated loans typically have a lower credit rating, and therefore a higher yield, than senior debt. While subordinated debt may be issued in a public offering, frequently, major shareholders and parent companies are the buyers of subordinated loans. These entities may prefer to inject capital in the form of debt, but due to the close relationship to the issuing company they may be more willing to accept a lower rate of return on subordinated debt than general investors would.

A particularly important example of subordinated bonds can be found in bonds issued by banks. Subordinated debt is issued periodically by most large banking corporations in the U.S. Subordinated debt can be expected to be especially risk-sensitive, because subordinated debt holders have claims on bank assets after senior debt holders and they lack the upside gain enjoyed by shareholders. This status of subordinated debt makes it perfect for experimenting with the significance

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of market discipline, via the signalling effect of secondary market prices of subordinated debt (and, where relevant, the issue price of these bonds initially in the primary markets). From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financial condition of the banks. This hopefully creates both an early-warning system, like the so-called "canary in the mine," and also an incentive for bank management to act prudently, thus helping to offset the moral hazard that can otherwise exist, especially if banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years.[1]

For a second example of subordinated debt, consider asset-backed securities. These are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later. Finally, mezzanine debt is another example of subordinated debt.

Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as asset-backed securities, collateralized mortgage obligations or collateralized debt obligations. Corporate issuers tend to prefer not to issue subordinated bonds because of the higher interest rate required to compensate for the higher risk, but may be forced to do so if indentures on earlier issues mandate their status as senior bonds. Also, subordinated debt may be combined with preferred stock to create so called monthly income preferred stock, a hybrid security paying dividends for the lender and funded as interest expense by the issuer.

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