Capital Adequacy Ratio (CAR)

Capital Adequacy Ratio (CAR) is a ratio that regulators in the banking system use to
watch bank's health, specifically bank's capital to its risk. Regulators in the banking
system track a bank's CAR to ensure that it can absorb a reasonable amount of loss.

Regulators in most countries define and monitor CAR to protect depositors, thereby
maintaining confidence in the banking system.

Capital adequacy ratio is the ratio which determines the capacity of a bank in terms of
meeting the time liabilities and other risk such as credit risk, market risk, operational risk,
and others. It is a measure of how much capital is used to support the banks' risk assets.

Bank's capital with respect to bank's risk is the simplest formulation; a bank's capital is
the "cushion" for potential losses, which protect the bank's depositors or other lenders.

Development of minimum capital adequacy ratios

The “Basle Committee” (centred in the Bank for International Settlements), which was
originally established in 1974, is a committee that represents all central banks .The
Committee concerns itself with ensuring the effective supervision of banks on a global
basis by setting and promoting international standards. Its principal interest has been in
the area of capital adequacy ratios.

In 1988 the committee issued a statement of principles dealing with capital adequacy
ratios. This statement is known as the “Basle Capital Accord”. It contains a
recommended approach for calculating capital adequacy ratios and recommended
minimum capital adequacy ratios for international banks. The Accord was developed in
order to improve capital adequacy ratios (which were considered to be too low in some
banks) and to help standardize international regulatory practice.

Capital

The calculation of capital (for use in capital adequacy ratios) requires some adjustments
to be made to the amount of capital shown on the balance sheet. Two types of capital are
measured in Pakistan - called tier one capital and tier two capital. Tier one capital is
capital which is permanently and freely available to absorb losses without the bank being
obliged to cease trading. An example of tier one capital is the ordinary share capital of
the bank. Tier one capital is important because it safeguards both the survival of the bank
and the stability of the financial system.

Tier two capital is capital which generally absorbs losses only in the event of a winding-
up of a bank, and so provides a lower level of protection for depositors and other

1
creditors. It comes into play in absorbing losses after tier one capital has been lost by the
bank. Tier two capital is sub-divided into upper and lower tier two capital. Upper tier two
capital has no fixed maturity, while lower tier two capital has a limited life span, which
makes it less effective in providing a buffer against losses by the bank.
An example of tier two capital is subordinated debt. This is debt which ranks in priority
behind all creditors except shareholders. In the event of a winding-up, subordinated debt
holders will only be repaid if all other creditors (including depositors) have already been
repaid.

The Reserve Bank does not require capital to be held against market risk, so does not
have any requirements for the holding of tier three capital. The composition and
calculation of capital are illustrated by the first step of the capital adequacy ratio
calculation example shown later in this article.

First step - calculation of capital

The composition of the categories of capital is as follows:

Tier one capital/ core capital

Paid-up Capital

Paid-up capital refers to shares issued by a company for which it has received the full
nominal value in payment.

The share premium account balances

The share premium account balances the difference between the par value of a company's
shares and the amount that the company actually received for newly issued shares.

Retained profit

Retained profit, or retained earnings, may appear on the balance sheet or the profit and
loss account. It is the amount of profit kept by the company rather than paid as dividends.

Intangible assets

Assets that do not have a definite existence are called intangible assets. They have neither
a physical form nor give their owner definite financial rights.

Intangible fixed assets are shown separately on the balance sheet from tangible fixed
assets.

2
General reserve

It is a reserve created by transferring certain amount of undistributed profit for funding

expansion, acquisition, paying dividends, discharging of liabilities, writing off
extraordinary and/or contingent losses, buyback and/or redemption of securities.

Tier 1 capital, the more important of the two, consists largely of shareholders' equity.
This is the amount paid up to originally purchase the stock (or shares) of the Bank (not
the amount those shares are currently trading for on the stock exchange), retained profits
and subtracting accumulated losses. In simple terms, if the original stockholders
contributed $100 to buy their stock and the Bank has made $10 in profits each year since,
paid out no dividends and made no losses, after 10 years the Bank’s tier one capital
would be $200
.
Regulators have since allowed several other instruments, other than common stock, to
count in tier one capital. These instruments are unique to each national regulator, but are
always close in nature to common stock. These are commonly referred to as upper tier
one capital. Tier 1 capital is the core measure of a bank's financial strength from a
regulator's point of view. It is composed of core capital, which consists primarily of
common stock and disclosed reserves (or retained earnings), but may also include non-
redeemable non-cumulative preferred stock.

Capital in this sense is related to, but different from, the accounting concept of
shareholders’ equity. Both tier 1 and tier 2 capital were first defined in the Basel I
Capital accord and remained substantially the same in the replacement Basel II Accord.

Each country's banking regulator, however, has some discretion over how differing
financial instruments may count in a capital calculation. This is appropriate, as the legal
framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against
unexpected losses. Note that this is not the same as expected losses which are covered by
provisions, reserves and current year profits.

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total assets.
The Tier 1 risk based capital ratio is the ratio of a bank's core (equity capital) to its total
risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank
which are weighted for credit risk according to a formula determined by the Regulator
(usually the country's Central bank). Most central banks follow the Bank for International
Settlements (BIS) guidelines in setting formulae for asset risk

3
Tier 2 capital/ supplementary capital
Tier 2 capital is a measure of a bank's financial strength with regard to the second most
reliable form of financial capital from a regulatory point of view. The forms of banking
capital were largely standardized in the Basel I accord, issued by the Basel Committee on
Banking Supervision and left untouched by the Basel II accord. National regulators of
most countries around the world have implemented these standards in local legislation.

Tier 1 capital is considered the more reliable form of capital, which comprises the most
junior (subordinated) securities issued by the firm. These include equity and qualifying
perpetual preferred stock.

There are several classifications of tier 2 capital. In the Basel I Accord, tier 2 capital is
composed of supplementary capital, which is categorised as undisclosed reserves,
revaluation reserves, general provisions, hybrid instruments and subordinated term debt.
Supplementary capital can be considered tier 2 capitals up to an amount equal to that of
the core capital.[1]

Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a bank
has made a profit but this has not appeared in normal retained profits or in general
reserves of the bank.

Revaluation Reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an
increase in value is brought to account. A simple example may be where a bank owns the
land and building of its head-offices and bought them for $100 a century ago. A current
revaluation is very likely to show a large increase in value. The increase would be added
to a revaluation reserve.

General Provisions

A general provision is created when a company is aware that a loss may have occurred
but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards,
general provisions were commonly created to provide for losses that were expected in the
future. As these did not represent incurred losses, regulators tended to allow them to be
counted as capital.

Hybrid Instruments

Hybrids are instruments that have some characteristics of both debt and shareholders'
equity. Provided these are close to equity in nature, in that they are able to take losses on
the face value without triggering a liquidation of the bank, they may be counted as
capital. Preferred stocks are hybrid instruments.

4
Subordinated Term Debt

Subordinated debt is debt that ranks lower than ordinary depositors of the bank.

Total capital

This is the sum of tier 1 and tier 2 capital less the following deductions:
• equity investments in subsidiaries;
• shareholdings in other banks that exceed 10 percent of that bank’s capital;
• unrealised revaluation losses on securities holdings.

Risk-Weighted Assets: This includes the total assets owned. The value of each asset is
assigned a risk weight (for example 100% for corporate loans and 50% for mortgage
loans) and the credit equivalent amount of all off-balance sheet activities. Each credit
equivalent amount is also assigned a risk weight.

Other names related to the Capital Adequacy Ratio CAR

Capital adequacy ratio (CAR) is often also called capital sufficiency ratio.

Instructions on Calculation of Capital Adequacy Ratio (CAR) by SBP:

1. Requirements as to calculation of CAR:

1.1 MFBs shall categorize their capital as Core Capital and Supplementary
Capital. The components of core & supplementary capital and the risk
weights are provided in the annexed Tables A and B respectively.

1.2 The inclusion of supplementary capital for calculating Capital Adequacy

Ratio shall be limited to 50% of the Core Capital.

2. Computation of Supplementary Capital

2.1 General Provisions or General Reserves for loan losses shall include only such
provisions which are not created against identified losses and are as such freely available
to meet unidentified losses. These provisions or reserves will be limited to maximum of
1.25% of total Risk Weighted Assets.

2.2 Revaluation Reserves shall be the Reserves created by revaluation of fixed assets and
equity instruments held by the MFB. The assets and investments must be prudently
valued fully taking into account the possibility of price fluctuations and forced sale.
Revaluation reserves reflecting the difference between the book value and the market
value will be eligible upto 50% for treatment under Supplementary Capital subject to the
condition that the reasonableness of the revalued amount is duly certified by the external
auditors of the MFB.

5
2.3 Sub-ordinated debt shall qualify for inclusion in the Supplementary Capital after
obtaining prior written approval from the SBP. Such approval will be granted by SBP on
case to case basis subject to fulfillment of the following conditions:

a) Sub-ordinated debt can be raised from any person or entity, preferably

from the sponsors, in local currency only.

b) Rate of profit will be decided by the MFBs, subject to SBP’s clearance.

c) The loan should be un-secured, plain vanilla and sub-ordinated as to payment of

principal and profit to all other indebtedness of the MFB including deposits.

d) The loan should have original fixed term to maturity of minimum 5 years.

e) The loan should not be repayable before the agreed repayment date without approval
of the SBP. Neither the interest nor the principal may be paid even at maturity if such
payments mean that the MFB falls below or remain below the capital adequacy ratio.

f) Any other restrictions imposed by the State Bank of Pakistan.

6
7
8
Example of a calculation of capital:

Calculation of capital

Tier 1/core capital

Ordinary capital 7
Retained earnings 8
less Goodwill -3
Total tier 1 capital 12

Tier 2/ supplementary capital

Upper tier 2
General bad debt provision 2
Revaluation reserve 4
Lower tier 2
Subordinated debt 2
Redeemable preference shares 3
Total tier 2 capital 11

Deduction
Shareholding in other bank -3

Total capital 20

Example of a calculation of risk weighted assets:

Calculation of risk weighted exposures

On-balance sheet
Exposure type X = Risk weighted exposures
Amount Risk weighting
Cash 11 0% 0
5 Year Govt Stock 20 10% 2
Lending to banks 30 20% 6
Home loans 52 50% 26
Commercial loans 64 100% 64
Fixed assets 25 100% 25

9
Total 123

Third Step - Calculation of Capital Adequacy Ratios

Capital adequacy ratios are calculated by dividing tier one capital and total capital by risk
weighted credit exposures.

Figure 5 shows an example of a calculation of capital adequacy ratios.

Figure 5

Calculation of capital adequacy ratios

Tier 1 capital to total 12 divided by 200 = 6%
weighted exposures =
Total capital to total risk
weighted exposures =

Advantages of using the Capital Adequacy Ratio CAR

In early phases of Basel implementations, bank's capital adequacy was calculated as

assets times’ ratio. This approach did not take risk profiles of assets into account. It is
obvious that a bank should keep more capital in reserves for riskier assets.

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. So, for
example, in the most basic application, government debt is allowed a 0% "risk
weighting". This also means that government debt is subtracted from total assets for
purposes of calculating the CAR.

On the other hand, investments in junior tranches of instuments collateralized with

subprime mortgages are very risky, and woudl be assigned 100% risk weighting.

USES OF CAR

1. Capital adequacy ratio is the ratio which determines the capacity of the bank in terms
of meeting the time liabilities and other risk such as credit risk, operational risk, etc.

2. In the simplest formulation, a bank's capital is the "cushion" for potential losses,
which protect the bank's depositors or other lenders.

3. Banking regulators in most countries define and monitor CAR to protect depositors,
thereby maintaining confidence in the banking system.

10
4. CAR is similar to leverage; in the most basic formulation, it is comparable to the
inverse of debt-to-equity leverage formulations.

5. Unlike traditional leverage, however, CAR recognizes that assets can have different
levels of risk.

CONCLUSIONS:

Capital adequacy ratios measure the amount of a bank's capital in relation to the amount
of its risk weighted credit exposures. The risk weighting process takes into account, in a
stylised way, the relative riskiness of various types of credit exposures that banks have,
and incorporates the effect of off-balance sheet contracts on credit risk. The higher the
capital adequacy ratios a bank has, the greater the level of unexpected losses it can absorb
before becoming insolvent.

The Basle Capital Accord is an international standard for the calculation of capital
adequacy ratios. The Accord recommends minimum capital adequacy ratios that banks
should meet.

REFERENCE:

 http://www.sbp.org.pk/bsrvd/2008/Annex-C7.pdf
 http://www.maxi-pedia.com/capital+adequacy+ratio+CAR
 http://web.archive.org/web/20070614200030/http://www.rbnz.govt.nz/finstab/ban
king/regulation/0091769.html
 http://en.wikipedia.org/wiki/Capital_adequacy_ratio

11