The guidelines with respect to capital standards and capital measures are widely laid down by the Basel Committee. Moreover, such underlying guidelines are being adhered to by India as well as other economies and India began implementing the Basel committee guidelines since 1992.
Capital Adequacy Ratio (CAR) or Capital to Risk (Weighted) Assets Ratio (CRAR) is a parameter signifying the financial strength as well as the stability of the banking concern. The ratio is a metric of the bank's capital with respect to its risk-weighted assets.
Capital Adequacy Ratio (CAR) or Capital to Risk (Weighted) Assets Ratio (CRAR) =
Tier-1 capital + Tier-2 capital/Risk weighted assets
Further, capital component of the CAR ratio includes Tier-1 capital together with Tier-2 capital. The nature of capital forming the part of the Tier-1 capital includes disclosed free reserve+paid-up capital+ statutory reserves less current and brought forward losses+ equity investments in subsidiary + intangible assets.
Hybrid debt capital requirements and subordinated debts+ general loss reserves and undisclosed reserves forms the part of Tier-2 capital.
The two components of the capital hold unique relevance as the Tier-1 capital provides banks with the ability to absorb or mitigate any kind of losses without stalling its banking activity. While, the tier-2 component of the capital cushions the bank during the winding-up process of the banking institution. Ergo, the tier-2 capital protects the interests of the depositors only to a small extent.
Further, in the given measure of financial strength, risk is either taken for weighted assets or the concerned nation's guidelines with regard to minimum overall capital requirement.
Implications of CAR
The measure holds considerable significance as it it determines bank's capacity to meet its time deposits as well as other risks including operational risks, credit risks etc. In this way, the CAR ratio very well takes into account different nature of risks that assets carry .
Capital Adequacy Ratio standards in India
The continuance of financial crisis over the long period in recent time propelled the government to mandate adherence to the norms relating to capital adequacy. It has been reported that the CAR of the entire banking system in India remained at 13.5% in the year ended 2012, of which Tier-I capital ratio stood at 9.7%.
Further of late, RBI rolled out Basel III capital norms for banking entities effective from April'2013. As per which, banks need to maintain a CAR of 9% that is otherwise 1% more than the global CAR standards of 8%. In its context, PTI reported the statement of D Subbarro, RBI Governor saying that a total amount exceeding INR 5lakh crore would be needed to comply with the Basel III capital requirements over the time frame of five years.