# CAR Mean Capital Adequacy Ratio

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.

# RWA Mean Risk Weighted Assets

Risk Weighted Assets is more of a concept than an asset. When a bank lends money, there is a chance some of it will not be paid back. The “some” that might not be paid back is the RWA. The Capital Adequacy Requirement (CAR) requires banks to maintain a Risk-Based Capital Ratio. This is a simple calculation of dividing Regulatory Capital with RWA. Regulatory Capital is the amount of Tier 1 and 2 capital a bank is required to possess at all times. Ideally, a bank would like to have a high Regulatory Capital and low RWA. The risk weights inflate bank assets. While larger assets are considered a good thing on the balance sheet, generally, in this case it is not. RWA valuation is not used to meet the SEC filing requirements. It is used to meet the Basel III requirements. There are 26 classifications of assets with varying risks. Each classification requires the bank to multiply assets by a Basel II prescribed risk weight.

Conceptually, here is what RWA looks like:
The bank lends \$100 to a borrower. This particular type of loan with this type of borrower has a significant chance of getting but just \$95. Because the risk of lose if \$5, the \$100 is multiplied by 105%. For this \$100 loan, it is a \$105 RWA. Banks are required to hold 1/10 in the Risk-Based Capital Ratio. Without the RWA, the bank would have to hold \$10 (1/10=\$10/\$100). But since the \$100 is being changed to an RWA of \$105, the bank now has to hold \$10.50 (1/10=\$10.5/\$105).

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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.