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Capital adequacy ratio

A capital adequacy ratio is a measure of financial health of bank.

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Contents

Expanded Definition

The capital adequacy ratio (CAR) of bank is calculated by taking the sum of bank's tier one capital and its tier two capital and dividing it by its risk-weighted assets. This measure is considered more reliable than the tier one capital ratio as it is more inclusive. It however excludes tier three capital. This term is also sometimes referred to as Capital to Risk Weighted Assets Ratio (CRAR). A bank is required by the Basel accords to have a CAR above 8% .

Use to Investors

In this modern day and age of accounting, investors are are best served to be suspicious of any results banks post. In the past a CAR was to be taken as a sign of conservative but sound banking. However in practice most banks only carry high ratios when they have gotten in financial trouble. In the modern age where level 3 assets and many hidden off balance sheet assets, CAR's relevance to the actual health of the bank and its ability to sustain losses is debatable and perhaps diminished from what it once was. Some investors instead now consider banks raising their CAR to be a bearish sign of a bank's future prospects. A low CAR should be considered a sign that a bank may cut its dividend, if it has one.

More practically an investor can use a bank's CAR to guesstimate a bank's leverage, although unlike traditional leverage metrics the CAR weights assets according to risk and thus is not completely translatable to traditional leverage metrics.

2008 Bailout Implications

The 9 banks that received equity injections from the Treasury under the TARP as a consequence saw their Capital adequacy ratios rise enormously. The government's hope is that this will encourage the banks to lend once more, unfreezing the credit market. This is ongoing as of this writing.

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