Capital Adequacy Ratio (CAR) also known as Capital to Risk (Weighted) Assets Ratio (CRAR). It is the ratio of banks capital to the risk. This ratio is used to safeguard the investors and encourage stability and effectiveness of financial systems in all over the world. CAR represents a banks capacity to meet its time liabilities and others risk such as Credit risk and Operational risk.
To compute CAR, two types of capitals are required i.e. Tier 1 Capital and Tier 2 Capital. Tier 1 Capital means which can absorb the loss without a bank require stopping its trading activities. On the other hand, Tier 2 Capital means which can absorb the loss in the event of dissolution, so Tier 2 Capital provide a lesser degree of security to the depositors.
Tier 1 Capital, Tier 2 Capital and CAR is calculated by way of following formula
Tier 1 Capital = (Paid up capital + Statutory Reserves + Disclosed free reserves) – (Equity investment in subsidiaries + Intangible assets + Current and brought forward losses)
Tier 2 Capital = (Undisclosed Reserves + General loss reserve + Hybrid debt capital instruments & subordinated debts)
CAR = Tier 1 Capital + Tier 2 Capital
Risk Weighted Assets