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Capital Adequacy Ratio [CAR] – Definition, Calculation and Importance

Capital Adequacy Ratio

Reserve Bank of India, having considered it necessary in the public interest and being satisfied that, for the purpose of enabling the bank to regulate the financial system to the advantage of the country keep on issuing some guidelines for the proper functioning of Banking and Non- Banking institutes. Capital Adequacy Ratio is also one of the guidelines provided by the RBI to measure the amount of capital a bank retains compared to its risk. In the year 2019, the concerns with regards to the credit risk of non-banking financial companies were raised in its assessment. Where is it was noted that around 8% of NBFC’s will not be able to comply with the minimum regulatory capital requirement of 15%, and around 12% of companies will not be able to comply with the minimum regulatory capital risk assets ratio norms.

What is Capital Risk Adequacy Ratio?

The capital adequacy ratio (CAR) is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposure. This is also known as a capital –to –risk-weighted asset ratio (CRAR), is used to protect and depositor a promote the stability and efficiency of the financial system around the world.

What are the Types of Capital?

There are two types of capital which are measured –

  1. Tier-1 capital, which can absorb the losses without a bank being required to cease trading
  2. Tier-2 capital, which can absorb losses at the time of winding –up and so provides a lesser degree of protection to the depositor.
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How to calculate Capital Adequacy Ratio?

The formula to calculate the Capital Adequacy Ratio (CAR) is calculated by dividing a bank’s capital by its risk-weighted asset. Hence, the formula is-

CAR= (TIER1 CAPITAL +TIER 2Capital)
Risk Weighted Assets

If we talk about the TIER 1 capital, this is the core capital and consists of the equity capital, ordinary share capital, intangible asset and audited revenue reserves. This type of capital is used to absorb the losses and does not require a bank to cease its operations. Such capital is one of the easily and permanently available capital which are available to cushion the losses incurred by the bank, without stopping its functioning. Tier 1 capital means owned funds as reduced by investment in the share of other NBFC and in share, debenture, bonds outstanding loans and advances including hire purchase and lease finance.

Here Owned Funds means, paid-up equity capital, preference share which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of assets, excluding reserves created by revolution of assets, as reduced by accumulated loss balances, book value of intangible assets and deferred revenue expenditure .

On the other hand TIER 2 capital compromises unaudited retained earnings, unaudited reserves, and general loss reserves. This capital is used at the time of winding up of company, so it provides less protection to the depositors and creditors.

Also, Read: RBI Guidelines for Mortgage Guarantee Company.

Tier 2 capital includes –

  • Preference share other than those which are compulsorily convertible into equity;
  • Revaluation reserves at a discounted rate of fifty-five percent;
  • Hybrid debt capital instruments
  • Subordinated debt
  • Excess of what qualifies for Tier 1 capital, to the extent the aggregate does not exceed Tier 1capital.
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What are Risk Weighted Assets?

Degrees of credit risk expressed as per percentage weightages have been assigned to balance sheet assets in the prudential norms. Risk weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutes to reduce to risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset.

Why Capital Adequacy ratio is Important?

The reason minimum capital is important because it ensures the efficiency and stability of a nation’s financial system by lowering the risk of banks being insolvent. The capital which bank hold with themselves as required by the financial regulator is known as a minimum capital requirement.  During the winding-up, funds belonging to the depositors are always given a higher priority than the bank capital, so depositors can only lose their savings only if a bank registers a loss exceeding the capital it possesses.

What is the Capital Adequacy Requirement?

  • The capital charge for credit risk and market risk needs to be maintained all the time.
  • In calculating eligible capital, it will be necessary first to calculate the PD’s minimum capital requirement for credit risk, and thereafter it’s market risk requirement to establish how much Tier-I and Tier II capital is available to support market risk. Of the 15% capital charge for credit risk, at least 50% capital charge for credit risk, at least 50% should be met by Tier-I capital, that is, the total of Tier- II capital, if any should not exceed one hundred percent of Tier-I capital, at any point of time, for meeting the capital charge for credit risk.
  • Subordinate debt as Tier-II capital should not exceed 50% of the Tier- I capital.
  • The total of Tier-II capital should not exceed 100% of Tier capital.
  • Eligible capital will be the sum of the whole of the PD’s Tier –I capital, plus its entire Tier – II capital under the limit imposed.
  • The overall capital adequacy ratio will be calculated by establishing an explicit numerical link between credit risk and market risk factors, by multiplying the market risk capital charge with 6.67 i.e the reciprocal of the minimum credit risk capital charge of 15%.
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What is the capital adequacy ratio for NBFC in India?

By March 2019, the capital adequacy ratio of the NBFC sector moderates at 19.3% from 22.8% in March 2018. The central bank also conducted stress tests on the NBFC sector and on the individual lender in order to gauge their resilience in an event of three stresses scenarios – baseline, medium and severe.

What are the RBI guidelines for standalone primary dealers?

The Reserve bank of India[1] (the bank), having considered it necessary in public interest and being satisfied that, for the purpose of enabling the bank to regulate the financial system to the advantage of the country and to prevent the affair of any Standalone Primary Dealer (SPD) from being conducted in manner detrimental to the interests of investor or in any manner prejudicial to the interest of such SPD, and in exercise of the powers conferred under section 45JA,45L and 45M of the reserve bank of India act, 1934,hereby issues to every SPD, in suppression of the list of circulars as provided for in chapter XI, the direction for in chapter XI, the guidelines are –

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Conclusion

Capital adequacy ratio measure the amount of the bank capital in relation to the amount of its risk weighted credit exposure. The Basle capital accord is an international standard for the calculation of capital adequacy ratios. This is to be believed that as much higher will be the capital adequacy ratio the greater the level of unexpected losses it can absorb before becoming insolvent.

Our Recommendation: NBFC Loan Against Shares RBI Guidelines.

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