what is the capital adequacy ratio 
the capital adequacy ratio car is an indicator of how well a bank can meet its obligations also known as the capital to risk weighted assets ratio crar the ratio compares capital to risk weighted assets and is watched by regulators to determine a bank s risk of failure it s used to protect depositors and promote the stability and efficiency of financial systems around the world two types of capital are measured tier 1 capital core funds on hand to manage losses so that a bank can continue operating and tier 2 capital a secondary supply of funds available from the sale of assets once a bank closes down 1investopedia michela buttignolunderstanding carthe capital adequacy ratio is calculated by dividing a bank s capital by its risk weighted assets currently the minimum ratio of capital to risk weighted assets is 8 under basel ii and 10 5 which includes a 2 5 conservation buffer under basel iii 23 high capital adequacy ratios are those that are higher than the minimum requirements under basel ii and basel iii a minimum capital adequacy ratio is critical in ensuring that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors funds the capital used to calculate the capital adequacy ratio is divided into two tiers the two capital tiers are added together and divided by risk weighted assets to calculate a bank s capital adequacy ratio 4 risk weighted assets are calculated by looking at a bank s loans evaluating the risk and then assigning a weight when measuring credit exposures adjustments are made to the value of assets listed on a lender s balance sheet all of the loans the bank has issued are weighted based on their degree of credit risk for example loans issued to the government are weighted at 0 0 while those given to individuals are assigned a weighted score of 100 0 tier 1 capital or core capital consists of equity capital ordinary share capital intangible assets and audited revenue reserves tier 1 capital is the capital that is permanently and easily available to absorb and cushion losses suffered by a bank without it being required to stop operating tier 2 capital comprises unaudited retained earnings unaudited reserves and general loss reserves tier 2 capital is the capital that absorbs and cushions losses in the case where a bank is winding up as such it provides a lesser degree of protection to depositors and creditors it is used once a bank loses all its tier 1 capital risk weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency the capital requirement is based on a risk assessment for each type of bank asset for example a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured by a house off balance sheet agreements such as foreign exchange contracts and guarantees also have credit risks such exposures are converted to their credit equivalent figures and then weighted in a similar fashion to that of on balance sheet credit exposures the off balance sheet and on balance sheet credit exposures are then added together to obtain the total risk weighted credit exposures the car formula c a r t i e r 1 c a p i t a l t i e r 2 c a p i t a l r i s k w e i g h t e d a s s e t s car dfrac tier 1 capital tier 2 capital risk weighted assets car risk weighted assetstier 1 capital tier 2 capital examplesuppose acme bank has 20 million in tier 1 capital and 5 million in tier 2 capital it has loans that have been weighted and calculated at 65 million the capital adequacy ratio of acme bank is therefore 38 20 million 5 million 65 million a car of 38 is a high capital adequacy ratio that means that acme bank should be able to weather a financial downturn and losses associated with its loans it is less likely than banks with less than minimum cars to become insolvent 