Banks are a popular investment for many shareholders. They are known for their strong financials and balance sheets. Many investors consider them to be a safe place to park their money because banks are strictly regulated. This means that the potential for major losses and insolvency is heavily reduced.
If you’re considering investing in the banking sector, it’s important to do your research. One of the ways you can do this is by reviewing some key financial ratios. These can help you track the financial performance of any potential investment in the banking sector. One of these is the capital adequacy ratio (CAR). In this article, we take a look at what this ratio is and what it means to investors.
Key Takeaways
- A bank’s capital adequacy ratio measures the amount of capital it has compared to its risk.
- This ratio indicates how well a bank can meet its financial obligations if it faces losses.
- The CAR helps shareholders understand the risks a bank takes with the equity it has, including shareholders’ equity.
What Is Capital Adequacy Ratio (CAR)?
The capital adequacy ratio measures the amount of capital that a bank retains compared to its risk. Put simply, it indicates how well a bank can meet its financial obligations and absorb any shocks related to losses.
National financial regulators track the CAR of banks and the financial system to determine how effectively they can sustain a reasonable amount of loss. Regulators must also determine whether a bank’s current CAR complies with statutory capital requirements as per regulations. The CAR is important to shareholders because it is an important measure of the financial soundness of a bank.
Banks are required to hold a certain amount of capital in their reserves. There are two types of capital that CAR measures:
- Tier 1 Capital: This category is also called a bank’s core capital. It comprises a bank’s equity capital and disclosed reserves. Tier 1 capital is able to absorb a reasonable amount of loss without forcing the bank to cease its trading.
- Tier 2 Capital: This category represents the second layer of capital. Tier 2 capital includes revaluation reserves, hybrid instruments, and subordinated term debt—all of which are harder to liquidate when the need arises. This makes this level of capital less secure than tier 1.
Calculating the Capital Adequacy Ratio (CAR)
In order to determine a bank’s CAR, you’ll need a few key figures. These are its tier 1 and tier 2 capital as well as its risk-weighted assets. These are the assets that a bank must hold in its reserves to cut down the chance of insolvency or failure.
To figure out the CAR, add a bank’s tier 1 and tier 2 capital then divide that result by its risk-weighted assets. Here’s the formula:
(Tier 1 + Tier 2) ÷ Risk-Weighted Assets
A lower ratio means that a bank isn’t well equipped to deal with losses. Meanwhile, the higher the ratio, the better off a bank is perceived to be in order to cushion itself from any negative shocks.
Regulations require that banks have a minimum ratio of capital to risk-weighted assets of 10.5% under Basel III, which are reforms that are meant to help banks limit risks.
Banks and Borrowing
The amount of shareholders’ equity within a bank is comparatively small compared to the funds borrowed and deposits made by its customers. Because of this, banks are typically highly leveraged, which requires banks to operate on a higher plane of borrowing than would be seen in most other businesses.
A bank’s liabilities typically exceed 10 times its equity capital. The greatest part of those liabilities represent smaller sums of money that customers deposit with the bank. Borrowers, on the other hand, are generally able to access loans and other financing roughly equal to their net worth. On the other hand,
Capital regulations require banks to maintain a minimum level of equity per loan and other assets because of the nature of the risk under which they operate. This required minimum is designed for protection, allowing banks to sustain unanticipated losses. This baseline is also designed to offer depositors confidence in the security of their deposits given the asymmetric information.
What Does This Mean for Shareholders?
An individual depositor cannot know if a bank has taken risks beyond what it can absorb. Thus, depositors receive a level of assurance from shareholders’ equity, along with regulations, audits, and credit ratings.
The amount of equity a bank receives from shareholders sets the limit on the value of deposits it can attract. This also limits the extent to which the bank can lend money. If a bank sustains large losses through credit or trading, eroding the bank’s net worth, this causes a decreased fund base through which a bank can offer loans.
The CAR provides shareholders with a better understanding of the risks that a bank takes with the equity it provides. A bank that continually takes more risks than it can reasonably sustain leaves potential shareholders with a sense their equity investments are more at risk.
A bank must maintain a professional level of risk management and sound lending practices to attract the capital that acts as its first line of defense against loss, both expected and unforeseen.
What Does Capital Adequacy Ratio Mean?
Capital adequacy ratio refers to a bank’s capital in relation to its risk. It indicates whether a bank is able to pay its financial obligations. Financial regulators use CAR to determine the financial soundness of banks. The higher the ratio, the better positioned a bank is when it comes to stability.
What Is an Acceptable Capital Adequacy Ratio?
There are thresholds that banks must adhere to when it comes to their capital adequacy ratios. These international standards require that banks have a capital adequacy ratio of 8% under Basel II and 10.5% under Basel III. Banks that fall under these limits do not meet regulatory standards and must improve their CARs.
How Can Banks Increase Their Capital Adequacy Ratios?
There are a few ways that banks can improve their capital adequacy ratios. One way is to increase the total capital required by financial regulators. They can also lower the total risk associated with the risk-weighted assets they hold.
The Bottom Line
Banks are generally considered safe investments because of their financials and the degree to which they are regulated. But before you dive in, it’s always a good idea to do your due diligence. One of the ways you can do so is by going over key financial metrics like the capital adequacy ratio. This can help you understand the amount of risk a bank takes with the equity it has on hand, including shareholder equity. A lower ratio means things can get risky. But if a bank’s CAR meets or exceeds the threshold set by financial regulators, it is well positioned if it faces losses.