Capital Adequacy Ratio for Banks (CAR): Why Does It Matter?

Under frameworks like Basel III and European directives such as CRD IV & V, CAR is one of the foundations for global banking stability.

It’s not just about meeting regulatory checkboxes, though.

It’s about ensuring that banks have enough loss-absorbing capital to absorb potential losses: safeguarding depositors’ money and maintaining confidence in the financial system.

Understanding the Capital Adequacy Ratio for Banks

The capital adequacy ratio (CAR) measures a bank's available going concern/core capital as a percentage of its risk-weighted assets (RWA).

It helps regulators and stakeholders gauge whether a bank has sufficient financial resources to withstand unexpected losses while continuing operations.

The formula is straightforward: CAR = (Tier 1 Capital / Risk-Weighted Assets)

Tier 1 Capital is the core loss-absorbing capital, including pure equity and revenue reserves. This is known as going concern capital.

Tier 2 Capital includes subordinated and convertible debt and only becomes available in the event of a bank's resolution/failure. It is not part of the CAR which comprises going concern loss-absorbing capital only.

Risk-weighted assets (RWA) are a bank's assets weighted by credit risk.

Tier 1 Capital: The Core Strength of a Bank

Tier 1 Capital is often called the core capital of a bank. Think of it as the primary safety net that absorbs losses without causing the bank to cease operations. It’s the most reliable form of capital because it’s permanent and doesn’t carry repayment obligations.

Components of Tier 1 Capital

1. Common Equity Tier 1 (CET1): This is the most important part of Tier 1 Capital and includes: Paid-up equity capital (the money raised from issuing common shares), disclosed reserves (retained earnings and other reserves like share premiums, and other comprehensive income (unrealised gains or losses from financial instruments, such as investments in bonds or stocks).
2. CET1 is crucial under Basel III, which requires banks to maintain a minimum of 4.5% of CET1 to RWA, ensuring they have high-quality, liquid capital to absorb immediate losses.
3. Additional Tier 1 (AT1) Capital: These are hybrid instruments that blend features of equity and debt, such as perpetual bonds (bonds without a maturity date, providing flexibility to the bank), and preference shares (non-cumulative shares that can absorb losses).
4. AT1 is less reliable than CET1 because it might involve some repayment conditions.

Why Tier 1 Capital Matters

Tier 1 Capital ensures a bank can absorb unexpected shocks—like a sudden loan default or market crash—while continuing to operate. Regulators, under Basel III, have raised the bar for Tier 1 Capital to ensure banks have a stronger cushion against financial risks.

Suppose a bank has $10 billion in Tier 1 Capital and $100 billion in RWA. Its Tier 1 CAR would be: 10% (10 billion ÷ 100 billion), well above the Basel III requirement of 6%.

Tier 2 Capital: The Secondary Defence

Tier 2 Capital is also known as supplementary capital. While it’s considered less robust than Tier 1, it’s still essential for a bank’s financial stability. Tier 2 Capital serves as a secondary buffer to absorb losses in the event that the institution fails, It is not available for ongoing operations.

Components of Tier 2 Capital

1. Subordinated Debt: Long-term debt instruments that rank below other liabilities. If the bank faces liquidation, subordinated debt holders are paid after depositors and other creditors.
2. Loan Loss Reserves: Provisions set aside to cover potential loan defaults.
3. Hybrid Instruments: Similar to AT1 instruments, but with slightly different terms and conditions.

Why Tier 2 Capital Matters

While Tier 2 Capital isn’t as liquid or reliable as Tier 1, it provides an additional safety cushion. It plays a crucial role in long-term financial health and helps banks meet their overall CAR requirements of 8% under Basel III.

Example: Let’s say a bank has £10 billion in Tier 1 Capital. If the bank’s RWA is £100 billion, its overall CAR would be: 10% (10 billion ÷ 100 billion)—well above the Basel III minimum.

Why Both Are Important

Tier 1 and Tier 2 Capital work together to ensure a bank’s resilience:

• Tier 1 Capital is like your primary health insurance: it’s there to cover immediate emergencies.
• Tier 2 Capital is your backup savings account: it helps when the primary source isn’t enough.

Requiring banks to maintain adequate levels of both, Basel III and CRD IV & V ensure that banks remain operational and can handle crises effectively.

Key Differences Between Tier 1 and Tier 2 Capital

Why CAR is Crucial Under Basel III and CRD IV & V

Here are three main reasons CAR matters:

1. Risk Management: A Pillar of Stability

Imagine a bank lending recklessly, offering loans to high-risk borrowers without considering their ability to repay.

Sounds like trouble, right?

Such behaviour not only endangers the bank but can also destabilise the broader financial system.

That’s where Basel III steps in, ensuring banks maintain a Capital Adequacy Ratio (CAR) of at least 8%. For every $100 of risk-weighted assets (RWA)—assets adjusted based on their level of risk—banks need to hold at least $8 in capital.

• Example: A home loan (lower risk) might require less capital backing than a loan to a startup (higher risk). This system discourages reckless lending while incentivising banks to weigh risks carefully.

Moreover, the leverage ratio introduced by Basel III acts as a backstop, ensuring banks maintain capital proportional to their total assets, regardless of risk. Together, these measures minimise the likelihood of insolvency during economic downturns, safeguarding not only individual institutions but the global economy.

2. Confidence in the Banking System: Strengthening Trust

A bank with a strong CAR sends a clear signal: “We’re prepared for tough times!” This instils confidence among depositors, investors, and regulators, who rely on the banking system’s stability for their financial security.

It’s like a sturdy safety net—providing reassurance that the bank can withstand financial shocks, such as a sudden increase in loan defaults or a market crash.

Case Study: During the 2008 financial crisis, many banks lacked sufficient capital buffers, eroding public trust and causing widespread panic. Basel III and subsequent reforms aim to prevent such scenarios by enforcing stricter capital requirements.

3. Regulatory Compliance: Adapting to Stricter Rules

The CRD IV & V (Capital Requirements Directives) frameworks translate Basel III’s global standards into actionable regulations for European banks. These rules go beyond the minimum CAR by introducing additional capital buffers that strengthen resilience:

• Capital Conservation Buffer (CCB): 2.5% Ensures banks build up extra capital during stable periods to absorb future losses.
• Countercyclical Capital Buffer (CCyB): Up to 2.5% Applied during economic booms to curb excessive lending and protect against future downturns.

For instance, if a bank operates in a country experiencing rapid credit growth, regulators may enforce a CCyB to ensure it remains prepared for potential economic slowdowns.

By meeting these enhanced requirements, banks not only avoid regulatory penalties but also position themselves as reliable institutions in the eyes of stakeholders.

This combination of risk management, trust-building, and compliance creates a more robust financial system that benefits everyone—from individual depositors to global economies.

Real-World Examples of CAR in Action

Example 1: UK Banking Industry

According to Statista, the average CAR of UK banks in Q2 2023 stood at a robust 19.3%—well above the Basel III minimum. This high ratio reflects the banking industry's cautious approach, ensuring they’re prepared for potential economic headwinds like inflation or geopolitical tensions.

Why such a high ratio?

Post-2008 financial crisis, regulators demanded stricter adherence to CAR requirements, and UK banks took note, strengthening their balance sheets.

Example 2: Silicon Valley Bank’s Collapse (2023)

On the flip side, consider the recent collapse of Silicon Valley Bank (SVB). While not in the UK, SVB’s fall highlighted the risks of having insufficient buffers. Despite meeting regulatory thresholds, mismanagement of interest rate risks eroded their capital base, leading to insolvency. This underscores the importance of not just meeting CAR but actively managing risks.

How Basel III and CRD IV & V Strengthen CAR

Key Enhancements Under Basel III

1. Higher Quality Capital Basel III emphasises Tier 1 capital, requiring it to comprise at least 6% of RWA.
2. Leverage Ratio An additional safeguard ensures banks don’t over-leverage beyond a ratio of ¾ or 5%.
3. Liquidity Requirements Rules like the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) work alongside CAR to ensure short-term and long-term liquidity.

CRD IV & V Additions

1. Systemic Risk Buffers Designed for banks considered "too big to fail," these buffers ensure additional capital for systemic players.
2. Pillar 2 Requirements Individual bank-specific assessments allow regulators to impose extra CAR thresholds based on unique risks.

Challenges Banks Face in Maintaining CAR

Banks must strike a fine balance between maintaining profitability and adhering to capital requirements. For instance, higher capital reserves can mean fewer funds available for lending, potentially dampening profits.

Economic downturns or market shocks, like those witnessed during the COVID-19 pandemic, can erode capital levels, forcing banks to raise capital during unfavourable conditions.

What Does the Future Hold?

With ever-evolving financial risks like cyber threats and climate change, regulators may impose stricter CAR requirements. Banking and corporate credit institutions must also invest in robust risk management systems and diversify their portfolios to ensure resilience.

Here's why this matters to you:

Whether you're a banker, regulator, or corporate credit professional, understanding CAR is crucial. It not only shapes the health of individual banks but also dictates the stability of the entire financial system. Learning about frameworks like Basel III and CRD IV & V empowers professionals to make informed decisions in their roles.

Want to deepen your understanding of CAR and its practical implications? Join our Bank Capital Adequacy Under Basel III and CRD IV & V course! Designed for finance professionals, this course explores: Basel III and CRD IV & V regulations in-depth, real-world applications of CAR, and strategies for risk management and compliance.

Equip yourself with the tools to navigate the complex world of bank capital requirements and take the next step in your career!

FAQ

Who decides the capital adequacy ratio?

The minimum capital adequacy ratio (CAR) is primarily set by international regulatory bodies like the Basel Committee on Banking Supervision (BCBS), under frameworks such as Basel III. These standards are then implemented and enforced by national and regional regulators, such as the European Banking Authority (EBA) for the EU (via CRD IV & V) and the Prudential Regulation Authority (PRA) in the UK. These regulators ensure banks maintain sufficient capital to absorb risks and protect depositors.