Capital Adequacy Ratio Step by Step calculation of CAR with Advantages

National regulators track a bank’s CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements. 1 This Table 5 does not cover equity exposures, which should be reported in Table 9 of this section. (i) Under the dollar-offset method of measuring effectiveness, the System institution must determine the ratio of value change (RVC). The RVC is the ratio of the cumulative sum of the changes in value of one equity exposure to the cumulative sum of the changes in the value of the other equity exposure. If RVC is negative and greater than or equal to −1 (that is, less than 0 and greater than or equal to −1), then E equals the absolute value of RVC. (3) If a System institution exceeds the 15-percent capital limitation provided in paragraph (h)(2) of this section, the capital treatment under paragraph (h)(1) of this section will continue to apply to any transfers of small-business obligations with retained contractual exposure that occurred during the time that the System institution did not exceed the capital limit.

Equity exposures, excluding exposures to an investment firm that would meet the definition of a traditional securitization in § 628.2 were it not for the application of paragraph (8) of that definition and has greater than immaterial leverage, to the extent that aggregate adjusted carrying value of the exposures does not exceed 10 percent of the System institution’s total capital. If a System institution has multiple securitization exposures that provide duplicative coverage to the underlying exposures of a securitization, the System institution is not required to hold duplicative risk-based capital against the overlapping position. Instead, the System institution may apply to the overlapping position the applicable risk-based capital treatment that results in the highest risk-based capital requirement. A System institution’s total risk-weighted assets for securitization exposures equals the sum of the risk-weighted asset amount for securitization exposures that the System institution risk weights under paragraph (a)(1) of this section, §§ 628.41(c), and 628.43, 628.44, or § 628.45, except as provided in paragraphs (e) through (j) of this section, as applicable. (1) A System institution that recognizes an eligible guarantee or eligible credit derivative in determining the risk-weighted asset amount for a hedged exposure must adjust the effective notional amount of the credit risk mitigant to reflect any maturity mismatch between the hedged exposure and the credit risk mitigant.

Risk weighting

An organization with a high Capital Adequacy Ratio has enough capital to cover losses. Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting. Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to “discount” lower-risk assets.

This ratio is used in business to protect from the financial crisis of a depositor and promotes stability and the efficiency of the financial system of the country. This ratio is used to check the adequate capital of a bank for the management of a certain amount of loss. Assets that do not show any chances of payment by the borrower to the concerned bank are non-performing.

Concept Capital Adequacy Ratio

Banks regard customers’ deposits more in times of dissolution or insolvent conditions. The capital adequacy ratio signals the incidence of such conditions and warns banking institutions against accepting assets with too many risks. The international regulatory framework Basel III requires banks to maintain a minimum capital adequacy ratio of 10.5%. When a bank’s capital adequacy ratio is high, it has enough capital to handle unforeseen losses. A bank faces a greater risk of failing when its CRAR ratio is low, and the regulatory authorities may thus order it to increase its capital.

Omnibus accounts established under 17 CFR parts 190 and 300 satisfy the requirements of this paragraph (a). Operating entity means a company established to conduct business with clients with the intention of earning a profit in its own right and that generally produces goods or provides services beyond the business of investing, reinvesting, holding, or trading in financial assets. All System banks, associations, and service corporations, and all unincorporated business entities, are operating entities.

Additional limitations on capital distributions may apply to a System institution under subpart C of this part and under part 615, subparts L and M, of this chapter. (C) The senior officer has no contractual right, whether express or implied, to the bonus payment. (G) Any similar transaction that the FCA determines to be in substance a distribution of capital. Unconditionally cancelable means, with respect to a commitment that a System institution may, at any time, with or without cause, refuse to extend credit under the commitment (to the extent permitted under applicable law). Two-way market means a market where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within 1 day and settled at that price within a relatively short timeframe conforming to trade custom.

Other assets backed by little or no collateral, such as a debenture, have a higher risk weighting. This is because there is a higher likelihood the bank may not be able to collect the loan. For example, if a bank has lent money to three different companies, the loans can have different risk weighting based on the ability of each company to pay back its loan. For example, suppose bank ABC has $10 million in tier-one capital and $5 million in tier-two capital. The capital adequacy ratio of bank ABC is 30 percent (($10 million + $5 million) / $50 million). Therefore, this bank has a high capital adequacy ratio and is considered to be safer.

Importance of the capital adequacy ratio

The tier-1 leverage ratio compares a bank’s core capital with its total assets. It is calculated by dividing Tier-1 capital by a bank’s average total consolidated assets and certain off-balance sheet exposures. The higher the tier-1 leverage ratio is, the more likely a bank can withstand negative shocks to its balance sheet. The capital adequacy ratio is calculated by dividing a bank’s capital by its risk-weighted assets. Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% (which includes a 2.5% conservation buffer) under Basel III. High capital adequacy ratios are those that are higher than the minimum requirements under Basel II and Basel III.

They are a trio of regulatory agreements formed by the Basel Committee on Bank Supervision. The Committee weighs in on regulations that concern a bank’s capital risk, market risk, and operational risk. The purpose of the agreements is to ensure that banks (and other financial institutions) always have enough capital to deal with unexpected losses. Suppose Acme Bank has $20 million in tier-1 capital and $5 million in tier-2 capital. The capital adequacy ratio of Acme Bank is therefore 38% (($20 million + $5 million) / $65 million). All of the loans the bank has issued are weighted based on their degree of credit risk.

The tier-1 capital of a banking institution, also known as core capital, can absorb losses without stopping financial activities. They are permanently available for transactions and are used to dampen losses in case of insolvent conditions. High CAR values indicate banks have enough capital to minimise damage caused by risk-bearing assets. Lower values may indicate that banks are suffering from multiple non-performing assets and gradually emerging into insolvency. A Capital adequacy ratio is a percentage of an adequate amount to be maintained to solve the risks situation of banks by them.

Risk-Weighted Assets

Such an entity or reference entity has adequate capacity to meet financial commitments if the risk of its default is low and the full and timely repayment of principal and interest is expected. The capital adequacy ratio (CAR) is a ratio between a bank’s accumulated capital and risk-weighted assets. The CAR is decided by central banks and regulators to prevent private banks from becoming insolvent.

• Under the alternative modified look-through approach, a System institution may assign the adjusted carrying value of an equity exposure to an investment fund on a pro rata basis to different risk weight categories under this subpart based on the investment limits in the fund’s prospectus, partnership agreement, or similar contract that defines the fund’s permissible investments.
• 3 A System bank can satisfy this requirement by describing the geographic distribution of its loan portfolio by State or other significant geographic division, if any.
• This is closely related to the safety and security of depositors in the financial organization.

Except as modified by paragraph (b) of this section, the exposure amount for a single OTC derivative contract that is not subject to a qualifying master netting agreement is equal to the sum of the System institution’s current credit exposure and potential future credit exposure (PFE) on the OTC derivative contract. Except for a sovereign exposure or a residential mortgage exposure, a System institution must determine a risk weight for an exposure that is 90 days or more past due or in nonaccrual status according to the requirements set forth in this paragraph (k). (ii) A System institution must assign a 20-percent risk weight to an exposure to a foreign bank whose home country is a member of the OECD and does not have a CRC. (1) A System institution must assign a 20-percent risk weight to an exposure to a GSE other than an equity exposure or preferred stock.

For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%. A minimum capital adequacy ratio is critical in ensuring that banks have enough cushion to absorb a reasonable current capital adequacy ratio amount of losses before they become insolvent and consequently lose depositors’ funds. (4) The ineffective portion of a hedge pair is (1–E) multiplied by the greater of the adjusted carrying values of the equity exposures forming a hedge pair.

(D) A System institution must use an OTC derivative contract’s effective notional principal amount (that is, the apparent or stated notional principal amount multiplied by any multiplier in the OTC derivative contract) rather than the apparent or stated notional principal amount in calculating PFE. (B) For purposes of calculating either the PFE under this paragraph or the gross PFE under paragraph (a)(2) of this section for exchange rate contracts and other similar contracts in which the notional principal amount is equivalent to the cash flows, notional principal amount is the net receipts to each party falling due on each value date in each currency. (3) For the purpose of this paragraph (g), if a System institution holds the first-lien and junior-lien(s) residential mortgage exposures, and no other party holds an intervening lien, the System institution must combine the exposures and treat them as a single first-lien residential mortgage exposure. (ii) The OFI meets capital, risk identification and control, and operational standards similar to the OFIs identified in paragraph (d)(1) of this section.

Protection amount (P) means, with respect to an exposure hedged by an eligible guarantee or eligible credit derivative, the effective notional amount of the guarantee or credit derivative, reduced to reflect any currency mismatch, maturity mismatch, or lack of restructuring coverage (as provided in § 628.36). Forward agreement means a legally binding contractual obligation to purchase assets with certain drawdown at a specified future date, not including commitments to make residential mortgage loans or forward foreign exchange contracts. Commodity derivative contract means a commodity-linked swap, purchased commodity-linked option, forward commodity-linked contract, or any other instrument linked to commodities that gives rise to similar counterparty credit risks. The capital adequacy of the banks has been improved in the financial year 2021 for better planning on capital resources and the generation of internal resources of the finance sector.

(ii) After considering these standards, the FCA may grant advance prior approval of an institution’s request to pay cash dividends and patronage or to redeem or revolve equity. Notwithstanding any such approval, an institution may not declare a dividend or patronage payment or redeem or revolve equities if, after such declaration, redemption, or revolvement, the institution would not meet its regulatory capital requirements set forth in this part and part 615 of this chapter. The CAR has major importance in the banking sector, especially in the commercial sector for maintaining the risk of the capital return. The CAR ensures the efficiency and stability of the financial systems of the nation by lowering the risk of the banks which are insolvent.