Understanding Capital Adequacy Ratio (CAR)

The Capital Adequacy Ratio (CAR), also known as the Capital to Risk-Weighted Assets Ratio (CRAR), is a key financial metric used primarily for banks. It measures a bank's capital in relation to its risk-weighted assets and is a crucial indicator of the bank's financial health, stability, and ability to absorb potential losses. Regulators worldwide use CAR to ensure banks don't take on excessive risk without adequate capital backing, thus protecting depositors and maintaining stability in the financial system.

The Formula

The CAR is calculated by dividing a bank's eligible capital by its risk-weighted assets, expressed as a percentage:

$CAR = \frac{\text{Total Capital (Tier 1 + Tier 2)}}{\text{Risk-Weighted Assets (RWA)}} \times 100\%$

The Tier 1 Capital Ratio is also often calculated:

$Tier\: 1\: Ratio = \frac{\text{Tier 1 Capital}}{\text{Risk-Weighted Assets (RWA)}} \times 100\%$

Components Explained:

• Tier 1 Capital: This is the bank's core capital, considered the highest quality and most loss-absorbing. It primarily consists of Common Equity Tier 1 (CET1) – common shares, retained earnings, disclosed reserves – and potentially Additional Tier 1 (AT1) instruments. It absorbs losses without requiring the bank to cease operations.
• Tier 2 Capital: This is supplementary capital, providing additional loss absorption capacity, but considered less reliable than Tier 1. It includes items like subordinated debt, general loan-loss reserves, revaluation reserves, and certain hybrid instruments. Tier 2 capital generally absorbs losses only in the event of liquidation.
• Risk-Weighted Assets (RWA): This is **not** the bank's total assets. Instead, it involves assigning risk weights to different asset classes based on their perceived credit, market, and operational risk. For example, cash or government bonds might have a 0% risk weight, while unsecured corporate loans might have a 100% or higher weight. The sum of these weighted asset values gives the RWA. **Calculating RWA is complex**, following specific regulatory frameworks (like Basel III or local adaptations) using either a Standardised Approach or Internal Ratings-Based (IRB) models. This calculator requires the final RWA value as an input.

Regulatory Requirements (Context)

International frameworks like **Basel III** set minimum requirements. For example, Basel III mandates a minimum Total CAR of 8% and a minimum Tier 1 CAR of 6%. Additionally, buffers like the Capital Conservation Buffer (CCB) of 2.5% are typically required, pushing effective minimums higher (e.g., Total CAR of 10.5%).

National regulators often set their own specific requirements, which may be higher than Basel minimums. For instance, the **Central Bank of Egypt** requires banks to maintain specific minimum ratios, which were reportedly well exceeded by the sector, with an average CAR of 19.1% by Q3 2024 against a likely minimum of 12.5% or similar. Always refer to the specific regulatory requirements applicable to the bank being analyzed.

Uses of CAR:

• Assessing a bank's solvency and financial resilience.
• Comparing the capital strength of different banks.
• Regulatory compliance and monitoring.
• Informing investor and depositor confidence.
• Influencing a bank's lending capacity.