Decode a bank’s financial position using the Capital Adequacy Ratio (CAR)

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. 

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.

How to calculate the capital adequacy ratio?

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:

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:

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.