Q. Consider the following statements:

  1. Capital Adequacy Ratio (CAR) is the amount that banks have to maintain in the form of their own funds to offset any loss that banks incur if the account-holders fail to repay dues.
  2. CAR is decided by each individual bank.

Which of the statements given above is/are correct?

  • 1 only
  • 2 only
  • Both 1 and 2
  • Neither 1 nor 2

Answer: (a) 1 only

Capital Adequacy Ratio (CAR):
  • Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk. It is also known as the Capital to Risk (Weighted) Assets Ratio (CRAR).
    • In other words, it is the ratio of a bank’s capital to its risk-weighted assets and current liabilities. This ratio is utilized to secure depositors and boost the efficiency and stability of financial systems all over the world.
  • It is measured as: Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets
    • The risk weighted assets take into account credit risk, market risk and operational risk.
  • It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
  • Criteria:
    • The Basel III norms stipulated a capital to risk weighted assets of 8%.
    • However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12%.
  • Tier 1 capital: This can absorb the losses without a bank being required to stop trading. Also called core capital, this consists of ordinary share capital, equity capital, audited revenue reserves, and intangible assets. This is permanently available capital and readily available to absorb losses incurred by a bank without it having to cease operations.
  • Tier 2 capital: This can absorb losses if the bank is winding-up and so gives depositors a lesser measure of protection. This consists of unaudited reserves, unaudited retained earnings, and general loss reserves. This capital cushions losses if the bank is winding up and is used to absorb losses after a bank loses all its tier 1 capital.
  • Risk-weighted assets: These assets are used to fix the least amount of capital that should be possessed by banks to lower the insolvency risk. The capital requirement for all types of bank assets depends on the risk assessment.