Capital Adequacy Ratio (CAR)

The financial system depends heavily on the stability of banks. For that reason, regulators closely monitor various indicators to ensure banks can withstand unexpected losses and protect depositors. One of the most critical indicators used for this purpose is the Capital Adequacy Ratio (CAR). This article explains CAR in simple language, suitable for those new to investing or financial terms.

Table of Contents

What is Capital Adequacy Ratio?
Understanding Capital Adequacy Ratio
Importance of Capital Adequacy Ratio
How to Calculate Capital Adequacy Ratio
Example of Capital Adequacy Ratio
Frequently Asked Questions

What is Capital Adequacy Ratio?

The Capital Adequacy Ratio (CAR), also known as the Capital to Risk-Weighted Assets Ratio (CRAR), is a financial metric used to assess a bank’s ability to absorb potential losses. It compares a bank’s capital to its risk-weighted assets (RWAs) and is expressed as a percentage.

This ratio helps ensure that banks have sufficient capital to absorb losses, particularly during economic or financial downturns. Regulators require banks to maintain a minimum CAR to protect the financial system from collapsing under stress.

Understanding Capital Adequacy Ratio

Banks earn profits by lending money, investing, and offering financial services. However, these activities come with risks—borrowers may default, investments might lose value, or operational problems could occur. To guard against these possibilities, banks must hold a minimum amount of capital.

CAR ensures that banks are not over-leveraged and have a solid capital base. If a bank faces losses, its capital is used first to absorb those losses, protecting customers’ deposits and limiting damage to the broader economy.

Capital is divided into two types:

Tier 1 Capital: The core capital, which includes common equity, retained earnings, and certain reserves. This is the most reliable form of capital as it is available to absorb losses while the bank remains a going concern.

Tier 2 Capital: Supplementary capital, which includes subordinated debt, revaluation reserves, and hybrid instruments. This capital is only activated if the bank is being liquidated.

Importance of Capital Adequacy Ratio

CAR is more than just a number—it plays a crucial role in maintaining the stability of the banking sector. Here’s why it matters:

Protects depositors’ money: With sufficient capital, a bank can cover losses without affecting customer deposits.

Ensures financial system stability: By maintaining healthy CAR levels, banks reduce the chances of collapsing, which could otherwise lead to broader economic issues.

Regulatory compliance: Banks must meet regulatory CAR requirements to operate legally in both domestic and international markets.

Supports lending growth: A strong Capital Adequacy Ratio (CAR) allows banks to lend more to consumers and businesses without breaching capital thresholds.

Boosts investor confidence: Investors and analysts often look at CAR as a measure of financial strength before committing funds to bank stocks or bonds.

How to Calculate Capital Adequacy Ratio

The formula for CAR is:

CAR = (Tier 1 Capital + Tier 2 Capital) ÷ Risk-Weighted Assets × 100%

Tier 1 Capital includes common shares, disclosed reserves, and retained earnings.

Tier 2 Capital includes instruments like subordinated debt and hybrid capital.

Risk-Weighted Assets (RWAs) refer to a bank’s assets weighted by credit risk. Higher-risk loans (like unsecured personal loans) are assigned more weight than low-risk ones (like loans to governments).

Example of Capital Adequacy Ratio

Hypothetical Example:

Let’s assume a bank in Singapore has:

Tier 1 Capital: SGX 1.5 billion

Tier 2 Capital: SGX 500 million

Risk-Weighted Assets: SGX 15 billion

CAR = (1.5 + 0.5) ÷ 15 × 100 = 2 ÷ 15 × 100 = 13.33%

This means the bank maintains a CAR of 13.33%, well above the regulatory minimum in Singapore, indicating strong financial health.

Real-World Examples (2024 Data):

United States: Major US banks, such as those subject to Federal Reserve stress testing, consistently report CARs above the 10.5% minimum set under Basel III. For instance, JPMorgan Chase reported a CAR of 15.2% in its 2024 quarterly filings, reflecting a robust capital position.

Singapore: According to the Monetary Authority of Singapore (MAS), top-tier banks such as DBS and UOB maintained total capital adequacy ratios (CARs) above 15% throughout 2024. This exceeds the MAS’s requirement of 10% Tier 1 and 12% total capital, signalling stability and responsible lending.

Frequently Asked Questions

What is the minimum Capital Adequacy Ratio requirement?

Under the Basel III framework, which is followed by regulators globally (including in the US and Singapore), the minimum total CAR is 10.5%, which includes a 2.5% capital conservation buffer.

In Singapore, banks must meet at least 10% for Tier 1 capital and 12% for total capital, as required by MAS.

In the US, banks designated as systemically important are required to maintain CARs above the 10.5% minimum depending on their size and risk profile.

What is the difference between Tier 1 and Tier 2 capital in CAR?

Tier 1 Capital is the core and most reliable form of capital. It includes ordinary shares, retained earnings, and disclosed reserves. It is available to absorb losses without forcing the bank to shut down.
Tier 2 Capital is supplementary and includes instruments like subordinated loans, which absorb losses only in the event of the bank’s failure.

How does Capital Adequacy Ratio impact a bank’s lending capacity?

Banks with high Capital Adequacy Ratio (CAR) levels are perceived as financially strong and can lend more without regulatory concerns. On the other hand, a low CAR limits a bank’s ability to expand its lending activities, as it needs to preserve capital to meet minimum requirements.

For example, if a US bank’s capital adequacy ratio (CAR) is too close to the minimum limit, it may pause large-scale lending until more capital is raised or risk-weighted assets are reduced.

Why do regulators monitor the Capital Adequacy Ratio closely?

Regulators monitor CAR to:

Ensure banks are not overexposed to risky assets.

Maintain confidence in the financial system.

Prevent a domino effect of bank failures during economic crises.

Enforce accountability and risk management within banks.

Regular CAR assessments help regulators detect early signs of trouble and take pre-emptive action to avoid a banking collapse.

What happens if a bank fails to maintain the required Capital Adequacy Ratio?

If a bank’s CAR falls below the regulatory threshold:

It may face penalties or restrictions on its operations.

Regulators can require the bank to raise fresh capital.

The bank might be barred from issuing dividends or making risky investments.

In extreme cases, the bank could be forced to merge with another institution or shut down operations to protect depositors.

In 2023, a mid-sized US bank was temporarily barred from expanding its loan portfolio after its capital adequacy ratio (CAR) dipped below acceptable levels due to a spike in non-performing assets. The Federal Reserve ordered immediate capital enhancement measures to restore the ratio.