What is capital adequacy ratio (CAR) in the case of banks and NBFCs?
Capital adequacy ratio or CAR is the ratio of Tier 1 Capital and Tier II capital to the risk weighted assets, of a banking or NBFC company. Tier 1 capital is the common equity and disclosed reserves of the company. Tier 2 capital consists of subordinate debt, hybrid instruments, revaluation reserves etc. Subordinate debt is debt that has secondary claim to other debt in case the banking company goes bankrupt. Hybrid instruments are those that have characteristics of both debt and equity. An example of hybrid instrument is convertible debentures. Assets of a bank or NBFC are mainly the loans that they give. Different weights are assigned to the different types of loans that these companies give.
The guidelines regarding the risk weights that have to be assigned to the different types of loans are given by Bank of International Settlements (BIS). Central banks can have risk weight- asset guidelines for their respective countries, based on BIS guidelines. An example of risk weighting of assets is that in case of government bonds that have a credit rating of AAA to AA-, risk weight of 20% should be assigned. Suppose a bank has Rs 100 worth of government bonds on its balance sheet. This bond has a rating of AAA. The bank will assign a risk weight of 20% to this bond. In calculation of total risk weighted assets for calculating CAR, the value of this bond will be Rs 20. In a similar way the risk-weighted asset value of the different assets are calculated.
The purpose of CAR is to indicate to the ability of a bank or NBFC to absorb losses in the case of materialization of extreme risks. A higher CAR means that a bank or NBFC has higher ability to absorb losses without going insolvent, in the case of materialization of extreme risks.
Under Basel III norms of BIS, the minimum CAR that banks should maintain is 8%. Under RBI’s current guidelines, public sector banks should have a CAR of at least 12%. Scheduled commercial private banks should have a CAR of at least 9%. NBFCs should maintain a CAR 10%.