Capital Adequacy Ratio is both a calculation and a standard. The calculation is:
(Tier 1 Capital + Tier 2 Capital) ÷ Risk Weighted Assets
The standard is 10%.
Accounting becomes very important in the final steps of this calculation because of the classification defined by Basel III.
- Tier 1 Capital are common stock, retained earnings and non-redeemable preferred stock.
- Tier 2 Capital are subordinated debt, hybrid instruments, revaluation reserves and undisclosed reserves.
Essentially, Tier 1 are what most people think of as shares of a corporation and what the bank has earned and retained over the years. Retaining the earnings rather than using it to provide dividends is a way to increase the assets of the organization, build a reserve to be deployed when needed. Tier 2 are preferred equity and long term debt the bank borrows, leverage.
The Capital is there to fund the business when business takes a sudden downturn. The 10% standard means that business can suddenly take a 10% dive and the bank will still be solvent. When CAR is 0%, the bank must start selling its assets to pay for its debts. One way to reduce the likelihood of avoiding this level is to be able to deploy borrowed funds that are due later to pay for the ones that are due currently. While this doesn’t mean the bank is healthy, but this gives the bank time to rebuild its reserves.
About the Author: Marcus Maltempo is a compliance professional with more than a decade of experience helping banks, law firms and clients manage investigations and regulatory responses.