# Capital Adequacy Ratio - Explained

What is a Capital Adequacy Ratio?

# What is a Capital Adequacy Ratio?

The capital adequacy ratio (CAR) is otherwise called Capital to Risk Assets Ratio (CRAR), it is the value of a banks capital as compared to its weighted risks. CAR seeks to assess the capital available to a bank and how this value influences its ability to pay liabilities and respond to credit exposures. Simply put, CAR indicates the ratio of a banks capital to its risk or credit exposures. CAR is important to regulators as it helps to determine the solvency of a bank or its ability to absorb losses given the available capital. CAR measures two types of capital which are tier-1 and tier-2 capital. The formula for calculating the capital adequacy ratio (CAR) is; Capital Adequacy Ratio Formula = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets

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## How Does a Capital Adequacy Ratio Work?

To calculate the capital adequacy ratio (CAR) of a bank, the capital of the bank will be divided by its risk-weighted otherwise known as risk-weighted exposures. Sine capital is categorized into two tiers; the two tiers are taken into consideration when calculating CAR.

## Tier-1 capital

This refers to the banks capital that grants it the ability to absorb losses and liabilities without the bank folding up. Examples of tier-1 capital include equity capital, intangible assets, ordinary share capital, and audited revenue reserves. This form of capital allows a bank attend to all liabilities without ceasing operations, it is also called the core capital.

## Tier-2 capital

Tier-2 capital allows a bank to pay liabilities and respond to credit risks even after it ceases operations, this capital provides an assurance to depositors that in the event of the bank folding-up, all liabilities will be paid. Examples of tier-2 capital are general loss reserves, unaudited retained earnings and unaudited reserves. The risk-weighted assets of a bank is determined by measuring its credit exposures and examining the risks of bank's loans. In calculating CAR, the tier-1 and tier-2 capitals are added up and divided by Risk-weighted assets.

## Risk-Weighted Assets

Risk-weighted assets are used to measure the amount of capital that must be held by a bank based on the ratio of assets weighted by risk. This is to help banks avoid inability to pay liability or settle credit exposures. Risk-weighted assets help to determine the capital requirement needed to cater for the risk of each asset.