Banks are an indispensable part of the economy. Do you agree? Well, there is no second thought about it.
Banks play a crucial role in facilitating individuals, businesses and the whole economy with monetary requirements for their operations. The primary function of a bank is to accept deposits from customers and lend them loans. With deposits comes the interest payments to customers. Check out the roles handled by investment banks with examples.
But how will a bank manage if it’s financially weak and unable to pay interest? How does one identify such weak banks? Today’s article is about a mathematical ratio that helps assess the same.
What is the capital adequacy ratio?
The capital adequacy ratio is a mathematical formula that compares a bank’s capital against its risk-weighted assets. It is also called Capital to Risk (Weighted) Assets Ratio (CRAR).
Risk-weighted assets are assets which are prone to risks. Concerning banks, loans are assets but are prone to the risk of non-payment by borrowers.
So, the capital adequacy ratio suggests the bank’s capacity to handle risky assets using its capital.
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How does the capital adequacy ratio work?
Banks, like all other organisations, require capital for their daily operations. Banks classify their capital into three separate tiers:
- Tier 1: The primary capital includes paid-up capital, disclosed statutory reserves, intangible assets, etc.
- Tier 2: It includes debt instruments, undisclosed reserves, preference shares, etc.
- Tier 3: Unsecured loans held by banks to meet emergency requirements.
Banks consider the total value of all three types while assessing the capital available against risks.
Banks get exposed to different kinds of risks. Of them, the primary risks are:
- Credit risks, where there is an uncertainty of loan repayment and timely interest payment from borrowers.
- Market risks, where the interest rates on deposits and loans change due to activities in the capital market.
- Operational risk, where errors in the bank’s systems lead to losses.
- The recent incident at UCO Bank is an example of how banks are prone to operational risks. The bank’s system erroneously credited ₹820 crores to its customer’s account.
Banks with good capital adequacy ratios should be able to handle these risks without affecting their customers, i.e., irrespective of losses, banks must be able to pay customers their interest on deposits.
Banks with low capital adequacy ratios represent their inability to meet their obligations. In such cases, the RBI (Reserve Bank of India) and the government take measures to infuse more capital.
Capital Adequacy Ratio Formula
Capital adequacy ratio formula = (Tier 1 capital + Tier 2 capital + Tier 3 capital) / Risk-weighted assets.
Let’s consider an example:
Bank A has the following capital and assets:
Equity capital ₹10,00,000
Reserves ₹2,00,000
Loans ₹50,00,000
Capital adequacy ratio:
Capital: ₹10,00,000 + ₹2,00,000 = 12,00,000
Risk-weighted assets: ₹50,00,000
Ratio = 24%
Bank B has the following capital and assets:
Equity capital ₹7,00,000
Loans ₹35,00,000
Capital adequacy ratio = 20%
In the above example, Bank A has a higher ratio, indicating a higher potential to handle risks.
Also read: What is equity share capital? [Explained]
Importance of capital adequacy ratio
The capital adequacy ratio is one of the primary numbers that determine the health of banks.
- It acts as a checkpoint for the central bank to monitor the performance of banks and take corrective actions when needed.
- The insolvency of banks affects its customers adversely as they may lose all their deposits. Hence, assessing the potential to manage risks and maintaining a good ratio helps the bank retain its goodwill.
- Banks are essential for the smooth functioning of the economy. So, the insolvency of banks impacts the economy negatively, as well.
Capital adequacy ratio in India
The capital adequacy ratio in India is decided by the Reserve Bank of India (RBI).
The Basel Committee of Banking Supervision introduced the concept of capital adequacy ratio in 1988. The RBI implemented this rule in India in 1992, based on the norms prescribed by the Basel Committee.
While the Basel Committee suggests 8% as the ideal capital adequacy ratio for banks, the RBI requires Indian commercial banks to have an adequacy ratio of 9%, and Indian public sector banks to have a ratio of 12%.
In November 2023, the RBI announced its latest update about risk-weighted assets. After noticing an increase in demand for consumer loans, the RBI has increased risk-weights on unsecured loans. The RBI is of the opinion that an increase in unsecured loans can also lead to an increase in defaults. So, raising the risk weight on such assets will tweak the capital adequacy ratio of banks. This is a caution for banks to be prepared to handle defaults without excess pressure.
Also read: Bank rate vs. Repo rate – Understanding the key differences
Top 5 public sector banks in India with the highest capital adequacy ratio, as of 31 March 2023:
| Bank | Ratio |
| Bank of Maharashtra | 18.14 |
| Punjab & Sind Bank | 17.10 |
| Canara Bank | 16.68 |
| UCO Bank | 16.51 |
| Indian Bank | 16.49 |
SBI, the largest commercial bank in India has a capital adequacy ratio of 14.68, as of 31 March 2023.
Top 5 private sector banks in India with the highest capital adequacy ratio, as of 31 March 2023:
| Bank | Ratio |
| The Catholic Syrian Bank Ltd. | 27.10 |
| Tamilnad Mercantile Bank Ltd. | 26.26 |
| City Union Bank Ltd. | 22.34 |
| Kotak Mahindra Bank Ltd. | 21.80 |
| IDBI Ltd. | 20.44 |
CAR vs the Solvency Ratio
CAR and the solvency ratio are both essential indicators of a bank’s financial health, but they serve different purposes and provide insights into different aspects of a bank’s ability to withstand challenges. CAR primarily focuses on the capital strength of a bank in relation to its risk-weighted assets. This helps determine whether the bank has enough cushion to absorb potential losses from credit, market, or operational risks without collapsing.
The solvency ratio, on the other hand, measures an institution’s ability to meet its long-term obligations. It takes into account all of the bank’s assets and liabilities to determine if the institution can continue operating smoothly.
Unlike CAR, which primarily assesses risk-weighted assets, the solvency ratio evaluates the entire financial structure, including liquidity and overall debt levels. This means it offers a broader perspective of a bank’s financial viability beyond just its exposure to high-risk assets.
While both ratios are indicators of financial stability, CAR is more focused on risk and the capacity of a bank to maintain adequate capital buffers. The solvency ratio provides an overview of a bank’s financial leverage and overall health.
CAR is essential for regulatory purposes, as it helps banking regulators like the RBI to ensure that banks have enough capital to stay afloat even during adverse situations. The solvency ratio is often of interest to stakeholders like investors and creditors, who want to assess whether the bank will remain solvent in the long term.
So, understanding the difference between these two ratios gives you a better insight into a bank’s ability to handle both expected and unexpected financial challenges.
Limitations of Using CAR
While CAR is a critical measure for understanding a bank’s ability to handle risks, it is not without limitations.
One of the main disadvantages is that CAR relies heavily on historical data and predefined risk-weighted assets. It does not always account for rapid changes in the financial environment or unexpected events that could affect a bank’s stability. For instance, a bank may have a high CAR, but a sudden economic crisis or market crash could still undermine its ability to manage risk, especially if the risk weights do not accurately reflect current realities.
Another limitation is the use of standardised risk weights, which may not always reflect the actual level of risk associated with certain assets. Banks often have different types of loans, some riskier than others, yet a standardised approach may simplify or underestimate the risk involved. This may give a misleading impression of a bank’s real risk exposure.
CAR also tends to overlook the quality of the bank’s assets. A high ratio may suggest a strong position, but if a significant portion of the capital is tied up in non-performing assets (NPAs), the bank might still be at risk. The quality and liquidity of a bank’s capital are as important as the capital itself, which the CAR might not adequately convey.
You should also note that since CAR focuses on maintaining a ratio, banks might look to boost their capital by increasing risky lending, expecting high returns, and thus artificially inflating the ratio. This “moral hazard” issue can lead to poor decisions that eventually put the bank at more risk instead of safeguarding it.
CAR is more of a regulatory tool than a comprehensive health indicator. It does not consider other factors like operational efficiency, liquidity management, or market dynamics, which are important for assessing the overall stability of a bank. Thus, while it is an essential measure for regulators, customers and investors should also look at other financial metrics before making decisions.
Bottomline
The capital adequacy ratio is not important for banks or the RBI alone. It is equally essential for customers as analysing the capital adequacy ratio of a bank gives customers an insight into the bank’s potential to repay their deposits and interests.
The capital adequacy ratio is a significant ratio for the RBI and banks while formulating monetary policies.
