Dhananjay Deepak (Articleship) (152 Points)
27 October 2008Have been hearing alot in these times about the capital adequecy ratio.
Tried finding out the formula of Capital adequecy ratio but could not find.
Can someone please tell me how is capital adequecy ratio calculated and what is the appropriate capital adequecy ratio that a company should maintain.
Awaiting a reply soon.
Regards,
Dhananjay
P.C.C Student
CA. Dashrath Maheshwari
(TaXpert)
(15090 Points)
Replied 27 October 2008
A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.
**DM
CA. Dashrath Maheshwari
(TaXpert)
(15090 Points)
Replied 27 October 2008
Contd...
This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
**DM
CA. Dashrath Maheshwari
(TaXpert)
(15090 Points)
Replied 27 October 2008
Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures.
Capital adequacy ratio is defined as
where Risk can either be weighted assets (
) or the respective national regulator's minimum total capital requirement. If using risk weighted assets,
≥ 8%.
The percent threshold (8% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator.
Two types of capital are measured: tier one capital (T1 above), which can absorb losses without a bank being required to cease trading, and tier two capital (T2 above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
Use:
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. In the most simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's depositors or other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk.
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. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR.
Risk weighting example:
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.
Bank "A" has assets totaling 100 units, consisting of:
Bank "A" has deposits of 95 units, all of which are deposits. By definition, equity is equal to assets minus debt, or 5 units.
Bank A's risk-weighted assets are calculated as follows:
| Cash | 10 * 0% = 0 |
| Government bonds | 15 * 0% = 0 |
| Mortgage loans | 20 * 50% = 10 |
| Other loans | 50 * 100% = 50 |
| Other assets | 5 * 100% = 5 |
| Total risk | |
|---|---|
| Weighted assets | 65 |
| Equity | 5 |
| CAR (Equity/RWA) | 7.69% |
Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equity-to-assets of only 5%, its CAR is substantially higher. It is considered less risky because some of its assets are less risky than others.
The Basel rules recognize that different types of equity are more important than others. To recognize this, different adjustments are made:
Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets may be 4%, while minimum CAR including Tier II capital may be 8%.
There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the jurisdiction.
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