'Capital Adequacy Ratio' is explained in detail and with examples in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
The Capital Adequacy Ratio refers to a metric for sizing up the capital of a given bank. It is usually written out in terms of a percentage of the risk weighted credit exposures of a bank. This formula is also referred to as CRAR or capital to risk weighted assets ratio. It is commonly employed to help ensure that the money from depositors is safeguarded while promoting the efficiency and stability of the globe’s various financial systems.
There are two different types of capital which this ratio measures. The first is Tier One Capital, able to absorb significant losses without causing a bank to stop trading. Tier Two Capital instead refers to those losses which will be sufficient to see through a bank wind down which actually offers less protection to the bank depositors. The official expression of CAR takes the form of Tier One Capital plus Tier Two Capital divided by the amount or Risk Weighted Assets.
Government regulators have determined that such minimum capital adequacy ratios are crucial in order to be sure that the various banks maintain a large enough cushion to suffer a reasonable sum in losses before the y fall into insolvency, having lost the funds of their depositors. By reducing the risks of banks sinking into insolvency, the Capital Adequacy Ratios make certain that the financial system of the nation are both providing stability and efficiency. When even one good-sized bank becomes officially insolvent, this shatters the financial system confidence potentially in a move that upsets the whole financial market system of the nation in which it occurs.
When such an insolvent bank is being wound down, the depositors’ funds receive the highest possible priority as compared to the capital of the bank. This means that depositors only have their savings at risk if the losses which the bank experiences are higher than the level of capital which it claims on its balance sheet. In other words, the larger the Capital Adequacy Ratio of the bank proves to be, the greater the amount of protection exists for the monies deposited by the bank depositors.
The Tier One Capital turns out to be that money which is constantly available and readily liquid in order to offset any losses which the bank suffers without having to cease operations. Ordinary share capital is considered to be a fine example for such Tier One Capital.
The Tier Two Capital by contrast is the amount which cushions depositors from losses when the bank winds down. It offers a significantly lower amount of protection to both the depositors and especially to the creditors. If the bank were to suffer the devastating loss of all of its Tier One Capital, this Tier Two Capital would be the one the bank fell back on subsequently.
Actually measuring the banks’ credit exposure requires making necessary adjustments to the asset values declared on the balance sheet of the lender. Every one of the loans the bank made will be weighted according to its degrees of risk. Loans which were made to the government or one of its agencies weight at zero percent. Those made to individuals receive a weighting of 100 percent for maximum potential risk.
There are also off-balance sheet agreements, foreign exchange guarantees and contracts that pose credit risks to the banks. These will be converted over to their credit equivalent amounts before being risk weighted according to the same design of the on-balance sheet credit kinds of exposures. Both on-balance and off-balance sheet credit exposures will finally be combined in order to come up with the final risk weighted credit exposures.
The United States sets its own minimum Capital Adequacy Ratio depending on the tier which the regulators assign to the individual bank in question. They do not allow the Tier One Capital for the bank as divided by its total risk weighted exposure to drop below four percent. The total capital requires that the full risk weighted credit exposure remains higher than eight percent.