What is Capital Adequacy Ratio ?

Definition

The Capital Adequacy Ratio (CAR) is a measure of a bank's ability to meet its obligations. Also known as the Capital to Risk (Weighted) Assets Ratio (CRAR), this ratio compares a bank's capital to its risk-weighted assets and is monitored by regulatory authorities to determine the risk of bank failure. It is used to protect depositors and promote the stability and efficiency of the global financial system.

Origin

The concept of the Capital Adequacy Ratio originated in the 1980s, taking shape with the introduction of the Basel Accords. In 1988, the Basel Committee released the Basel I Accord, which first established standards for capital adequacy to ensure banks had sufficient capital to withstand financial risks.

Categories and Features

Capital Adequacy Ratio is measured using two types of capital: Tier 1 and Tier 2 capital. Tier 1 capital is the core capital, which is readily available to absorb losses so that the bank can continue operating. Tier 2 capital is supplementary capital, which is realized from the sale of assets if the bank is closed. Tier 1 capital is generally considered more reliable as it includes equity and retained earnings, while Tier 2 capital includes subordinated debt and other hybrid capital instruments.

Case Studies

During the 2008 financial crisis, many banks' capital adequacy ratios came under scrutiny. For example, the collapse of Lehman Brothers was partly due to its inadequate capital adequacy ratio, which failed to withstand market volatility. In contrast, JPMorgan Chase maintained a higher capital adequacy ratio, successfully navigating the crisis and demonstrating robustness in risk management.

Another example is the Industrial and Commercial Bank of China, which maintained a high capital adequacy ratio during the global financial crisis, ensuring its stability and credibility in international markets.

Common Issues

Investors might encounter issues such as misunderstanding the differences between Tier 1 and Tier 2 capital and how to accurately assess a bank's risk-weighted assets when applying the capital adequacy ratio. A common misconception is that a higher capital adequacy ratio is always better, but in reality, an excessively high ratio might indicate that a bank is not effectively utilizing its capital for profitable investments.