3.
Explanation
The Capital Adequacy Ratio (CAR) is a key financial metric used to assess a bank’s stability and its ability to absorb losses while continuing to operate effectively. It is a regulatory requirement that helps ensure the soundness of a financial institution. CAR is typically expressed as a percentage and is calculated by dividing a bank’s capital by its risk-weighted assets. There are two common components of capital in this calculation:
1. Tier 1 Capital: This represents a bank’s core capital and includes common equity and retained earnings. Tier 1 capital is considered the most reliable form of capital and the primary source of a bank’s financial strength.
2. Tier 2 Capital: This includes subordinated debt, preferred stock, and other financial instruments that provide additional capital but with more risk compared to Tier 1 capital.
The denominator in the CAR calculation, “risk-weighted assets,” refers to the bank’s assets adjusted for risk. Different types of assets carry different levels of risk, and these are weighted accordingly. For example, loans to governments or highly rated corporations typically have lower risk weights than loans to riskier borrowers.
The minimum CAR requirement is set by banking regulators to ensure that banks have a sufficient buffer to cover unexpected losses. The specific CAR requirements may vary by country and are often a part of the Basel III international banking standards.
A healthy CAR indicates that a bank has a strong financial position and is better prepared to withstand financial shocks and economic downturns. Regulators use CAR to monitor and enforce capital adequacy standards in the banking industry, with the goal of safeguarding the stability of the financial system and protecting depositors and investors.