The capital adequacy ratio (CAR) is a measure of a bank’s ability to absorb losses in a stressful financial environment. It is a key liquidity ratio that measures the amount of capital a bank has relative to its total assets.

Formula:

Capital Adequacy Ratio (CAR) = Tier 1 Capital/Total Assets

Components of Tier 1 Capital:

• Common equity
• Retained earnings
• Other retained items

Components of Total Assets:

• Loans and advances
• Deposits
• Debt securities
• Other assets

Interpretation:

• A CAR above the regulatory minimum (usually around 8%) indicates that the bank has sufficient capital to absorb losses and maintain its solvency.
• A CAR below the minimum indicates that the bank may be at risk of insolvency if it experiences significant losses.
• Banks with higher CARs are generally considered to be more resilient to financial shocks.

Regulatory Significance:

The CAR is a key regulatory metric used by central banks to assess the overall health of banks and ensure their stability. Minimum CAR requirements are set by regulators to prevent bank failures and protect depositors.

Additional Factors:

• The CAR is a static ratio that does not account for changes in the bank’s assets and liabilities over time.
• Banks may have different risk profiles, so a CAR alone does not provide a complete picture of their financial health.
• Economic conditions and market volatility can also affect bank capital adequacy.

Example:

A bank has total assets of $10 million and Tier 1 capital of $2 million. Its CAR would be:

CAR = $2 million / $10 million = 20%

This indicates that the bank has 20% of its total assets in Tier 1 capital, which is above the regulatory minimum of 8%.