Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR) is a ratio of a bank's capital to its risk. Regulatory authorities track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements. CRAR determines the capacity of the bank in terms of meeting the time liabilities and other risks such as credit risk, operational risk, etc. In simple terms, a bank's capital is the "cushion" for potential losses, which protects the bank's depositors or other lenders.
Capital consists of Tier I capital (share capital + reserves) and Tier-II capital (subordinated debt, revaluation reserves etc). Risk weighted assets are calculated by applying risk weights to the assets of the Bank as per their risk profile or regulatory requirements.
In India the Reserve Bank of India has prescribed a minimum CRAR of 9% for all Banks operating in India. Out of the total CRAR of 9%, a minimum of 6% should be Tier I CRAR i.e. made up of only the share capital and free reserves. RBI stipulates strict penalties for Banks not adhering to 9% CRAR norm. In the extreme, the RBI can even order cancellation of the banking licence of the Bank which has continuously failed to maintain the minimum CRAR of 9%
Till 2009, the Banks in India used to calculate CRAR under the BASEL-I regime which involved simple calculations and related mostly to financial parameters. With effect from March 2010, all banks are required to calculate CRAR under the advanced BASEL-II approach which takes into consideration various risk factors viz- credit risk, operational risk etc. the BASEL-II approach is considered more stringent as it concentrates heavily on risk weighted assets. The highest risk weight that BASEL-II prescribes is 600%. Risk weights are even attached to off balance sheet items which do not have any financial implication but lead to maintenance of higher capital to absorb the risks of off balance sheet exposures.
For further information refer
CA Rahul Joglekar
Partner
Gokhale & Sathe
Chartered Accountants
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