The capital Adequacy Ratio is a bank’s capital to its risk ratio. This ratio is also known as the capital to risk-weighted asset ratio. Capital Adequacy Ratio is a set standard to measure a bank’s ability to pay liabilities, which means it is the ratio that gives the capacity of a bank to meet the time liabilities and other risks such as operational risk, credit risk, etc. The bank has a good Capital Adequacy Ratio; having enough capital to absorb potential losses means the bank has a low risk of becoming insolvent and losing depositor money. To secure the depositors and enhance stability after the 2008 financial crisis, the Bank for International Settlement (BIS) is stringent on the Capital Adequacy Ratio. There are two types of capital for Capital Adequacy Ratio based on Basel III that can be measured: (i) Tier 1 capital. (ii) Tier 2 Capital. Capital Adequacy Ratio is found using the following formula,
Where,
Tier 1 Capital is the capital (equity capital) that can take in the losses without a bank being required to halt all operations. Tier 1 capital is also known as core capital and is the most reliable form of capital.
Tier 2 Capital is the capital that can take in losses in the event of winding up, and thus it provides less protection to depositors. Tier 2 Capital is also known as additional capital that is less permanent and calculates the bank’s financial strength concerning the second most dependable form of financial capital.
Risk-weighted assets are the sum of the bank’s credit exposures, including appearing and non-appearing on the bank’s balance sheet. A Risk-Weighted asset considers the bank’s asset or off-balance sheet exposure, weighted according to the risk, and is used to figure the Capital Adequacy Ratio (CAR) for a financial institution. The Basel Committee guidance for assets of each credit rating slab is used for calculating Risk-weighted Assets.
Example of finding a Capital Adequacy Ratio is –
There is Bank A with having Tier 1 Capital is Rs.4,000/- and Tier 2 Capital is Rs.1,500/- with a landed Debenture (X) of Rs.9,500/-, a Mortgage loan (Y) of Rs.44,000/- and a Loan to the Government (Z) of Rs.5,000/-. Risk-weighting for Debenture, Mortgage loan and Loan to the Government is 90%, 75%, and 0% respectively.
So,
Tier 1 Capital + Tier 2 Capital = Rs.4,000 + Rs.1,500 = Rs.5,500
Risk Weighted Assets = 90% of X + 75% of Y + 0% of Z
= 90% of Rs.9,500 + 75% of Rs.44,000 + 0% of Rs.5,000
= Rs.8,550 + Rs.33,000 + Rs.0
= Rs.41,550
Thus,
Capital Adequacy Ratio = 13.233%
Bank has to maintain Capital Adequacy Ratio based on BASEL I, BASEL II, and BASEL III guidelines.
BASEL I Guideline
Basel Committee on Banking Supervision (BCBS) has recommended a set of guidelines on minimum capital requirements for banks in 1988, known as the Basel I accord. This accord was mainly focused on Credit Risk. Bank reserves were differentiated into separate risk categories, with different credit risk weights varying from 0 to 150. Specifically, banks were recommended to retain at least 8 percent of the Capital Adequacy Ratio, but the Reserve Bank of India had ordered at least 9 percent of the Capital Adequacy Ratio to be retained in India. Credit risk and Market risk are covered under Risk-weighted Assets as per Basel I accord.
BASEL II Guideline
Basel II accord is known as a modified framework for International Convergence of capital measurement and capital Standard, and it was introduced by the Basel Committee on Banking Supervision (BCBS) in the year 2004. Basel II accord is covered operational risks that are not covered under Basel I accord. The Basel II accord guarantees that the bank has adequate resources to cover the danger that the bank has been exposed to by lending with a view to ensuring that the greater the exposure of the bank to substantial risk, the greater the amount of capital that the bank has to maintain to defend against solvency and economic stability. Minimum Capital Requirement, Supervisory Review of Capital Adequacy, and Market Discipline are three pillars of the Basel II accord. Basel II accords were implemented in most economies, including India, at the beginning of the year 2008. Principally banks were advised to maintain a minimum of 8% of the Capital Adequacy Ratio, but in India, the Reserve Bank of India had ordered to keep a minimum of 9% of the Capital Adequacy Ratio. Credit Risk and Market Risk are covered under Risk-weighted Assets as per Basel I accord.
BASEL III Guideline
The Basel Committee on Banking Supervision (BCBS) is agreed on the Basel III accord in the year 2010, which was published in the year 2009 due to a credit crisis in the year 2008; with scheduled to implemented from 1st April 2013 and has now been allowed to be fully implemented up to 1st January 2022.
Basel III accords focus on a continuous process to increase the banking regulatory framework on bank capital adequacy, stress testing, and market liquidity risk with improvisation in the banking regulation, supervision, and risk management. Basel III accords strengthen bank capital requirements by enhancing bank liquidity and reducing bank leverage.
Tier 1 Capital and Tier 2 Capital have been introduced in Basel III accords. Minimum Tier 1 Capital is required up to 7.00%, and Minimum Tier 2 Capital is required up to 2.00 % of total weighted assets based on Basel III accords. Risk-weighted assets are the same as Basel II accords. Minimum Capital Adequacy Ratio is required up to 9.00%, but RBI has set an 11.50% Capital Adequacy Ratio and 4.50% Leverage Ratio (the proportion of bank’s debts compared to bank’s equity/capital) in Basel III accords, which increase the capital requirement of banks.
These days Banks should seek after BASEL III accords. However, it is not easy by the Government to influence the capital in the Public Sector Banks, so the Government launched Indradhanush – a seven-point plan for Public Sector Banks in August 2015 to restore market confidence in Public Sector Banks and with the adequate capitalization of Public Sector Banks.