Capital Adequacy Ratio (CAR)

Introduction

A financial institution is exposed to several risks that can emanate from both on- and off-balance-sheet
activities that can ultimately threaten the survival of the institution which is, insolvency. In order to shield
itself from these risks, the financial institution must have enough capital.

Capital primarily has four functions. First, capital is used to absorb any unanticipated losses that could
consequently damage the financial institutions reputation and continue as a going concern. Second,
capital is used to protect uninsured depositors, bondholders and creditors in the event of insolvency and
liquidation. Third, insurance funds also merit protection when a financial institution is adequately
capitalized. Finally, capital is necessary to fund the operations of a financial institution.

The importance of capital in financial institutions is one of the most crucial factors to ensure the solvency
of a financial institution. Ratios have been designed and implemented in order to measure how well a
financial institution is capitalized.

Capital Adequacy Ratios: Capital-assets Ratio

In 1991, the FDIC required all depository institutions to adopt capital requirements. The capital-assets
ratio measures the ratio of a depository institutions book value consisting of core capital to the book
value of its assets. This capital adequacy ratio is expressed as:

L = Core Capital / Assets

The numerator of the ratio is composed of a depository institutions book value of common equity plus
qualifying cumulative perpetual preferred stock plus minority interests in equity accounts of consolidated
subsidiaries. The denominator on the other hand is comprised of the book value of its assets. The FDIC
Improvement Act of 1991 assesses a depository institutions capital adequacy according to where its ratio,
L, falls under in one of the five target zones below:

Zone L
Well capitalized 5% or above

Adequately capitalized 4% or above

Undercapitalized Under 4%

Significantly undercapitalized Under 3%

Critically undercapitalized 2% or under

Since december 1992, regulators must take prompt corrective action (PCA) whenever a depository
institution falls below zone 1 or well capitalized.

Unfortunately, the initial ratios have three inherent problems. The first is that it does not take into
account Market Value since the process of crafting the equation only records book value. Second, the
denominator with total assets is an absolute value and does not take into account the corresponding
risks associated with its asset composition. Finally, off-balance-sheet activities are completely neglected.

Capital Adequacy Ratios: Risk-Based Capital Ratio

In light of the limitations by the aforementioned ratio, the U.S. regulators agreed with other members of
the Bank for International Settlements to phase in an improved capital adequacy ratio under what has
known to become Basel I. Basel 1 explicitly took into account credit risks of both on and off balance sheet
activities into the capital adequacy ratio. Market risk and operational risk was incorporated shortly after.
The table below shows the three mutually reinforcing pillars which thoroughly discusses and
encapsulates these risks as well as additional regulatory rules and requirements:

Pillar 1 Pillar 2 Pillar 3

Calculation of regulatory Regulatory supervisory review Requirements on rules for

minimum capital requirements
so as to complement and
enforce minimum capital
requirements calculated under
Pillar 1
disclosure of capital structure,
risk exposures, and capital
adequacy so as to increase
transparency and enhance
market/investor discipline

Credit risk

Market risk

Operational risk

Below is the timeline of the regulations and revisions:

1993 Basel 1 incorporated different credit risks

1998 Revision incorporated market risk

2001 The New Basel Capital Accord incorporated operational risk

2006 Basel II introduced the three mutually reinforcing pillars

Given the incorporation of these risks, particularly credit risk, the new capital adequacy ratio is now
expressed as:

Total risk-based capital ratio = (Tier I + Tier II Capital) / Credit risk-adjusted assets

In order to be adequately capitalized for international standards, a DI must hold a minimum capital
adequacy ratio of 8%. In addition, the Tier I core capital component ratio, Tier I / Credit risk-adjusted
assets, must have a minimum of 4%. Like the rubrics in the aforementioned five target zones, the same
applies to the new capital adequacy ratio.

Measurements and Calculations: Capital

Capital is divided into two tiers. Tier I consists of the primary or core capital. while Tier II capital is a wide
array of secondary capital resources. In order to calculate for the numerator, Tier I and Tier II capital must
be added. Then, additional deductions must be subtracted from the summation of the two capital tiers.
Below is a table that shows the summary of the components of both Tier I and Tier II capital and the
necessary deductions:

Tier 1 Tier II Deductions

Common stockholder's equity Allowance for loan and lease Investments in unconsolidated
losses subsidiaries

Qualifying cumulative and Nonqualifying perpetual Reciprocal holdings of banking

noncumulative perpetual preferred stock organizations capital securities
preferred stock

Minority interest in equity Hybrid capital instruments, Other deductions as determined

accounts of consolidated perpetual debt, and mandatory by supervisory authority
subsidiaries convertible securities

Less: Goodwill Subordinated debt and

intermediate-term preferred
stock

Revaluation reserves

Measurements and Calculations: Credit Risk-Adjusted Assets

Basel II mandates that risk-adjusted assets must be used in computing for the CAR. There are two
components that comprise the risk-adjusted assets: (1) on-balance-sheet and (2) off-balance-sheet credit
risk-adjusted assets.

Prior to Basel II, Basel I initially had broad categories of borrowers which risk weights depended on. For
instance, all corporate loans have risk weights of 100% without taking into account the particular firms
credit risk. The Basel II circumvented this problem by introducing a wider differentiation of credit risk
weights. There are five categories of credit risk exposure. The following table exhibits the risk categories
along with the descriptions for international requirements:

Weight Items

0% Cash, Federal Reserve Bank balances,

securities of

20% Cash items in the process of collection,

US and OECD interbank deposits and
guaranteed claims

50% Loans fully secured by first liens on one-

to four-family residential properties.
Other municipal bonds. Loans to
sovereigns with a credit rating of BBB+
to BBB-. Loans to banks and corporates
with a credit rating of A+ to A-

100% Loans to sovereigns with a credit rating

of BB+ to B-. Loans to banks with a
credit rating of BBB+ to B-. Loans to
corporates with a credit rating of BBB+
to BB- and unrated C&I loans. All other
on-balance-sheet assets not listed
above including loans to private
entities and individuals
 Weight Items

150% Loans to sovereigns, banks, and

securities firms with a credit rating
below B-. Loans to corporates with a
credit rating below BB-
Sources: www.federalreserve.gov, www.bis.org

In order to compute for the credit risk-adjusted on-balance-sheet assets, the dollar amount of each assets
must be multiplied by the appropriate risk weight corresponding to its category. All assets are then
summed.

The second component is the credit risk-adjusted off-balance-sheet activities. These are activities are not
the actual claims against the depository institutions and are not displayed in its full face value. Rather,
these activities are contingent claims and the are held against the equivalent amount to any eventual on-
balance-sheet credit risk that these securities might create for a depository institution.

In order to compute for this, off-balance-sheet activities must be first converted to credit equivalent
amounts which are amounts equivalent to an on-balance-sheet activity. The following table exhibits the
conversion factors along with the descriptions of the mandated items:

Conversion Factor Off-balance-sheet Activity

100% 1. Sale and repurchase agreements and

assets sold with recourse that are not
included on the balance sheet
2. Direct-credit substitute standby
letters of credit

50% 1. Performance-related standby letters

of credit
2. Unused portion of loan
commitments with original maturity
of more than one year

20% 1. Unused portion of loan

commitments with original maturity
of one year or less
2. Commercial letters of credit
3. Bankers acceptance conveyed

10% 1. Other loan commitments

Sources: www.federalreserve.gov

In order to compute for the corresponding credit equivalent amounts, the dollar amount of each off-
balance-sheet activity must be multiplied by the appropriate conversion factor corresponding to its
category. Once the credit equivalent amounts are derived, the dollar value that results from this must be
multiplied to a risk weight to produce the final credit risk-adjusted asset amount for OBS activities.

Given that both on-balance-sheet and off-balance-sheet activities are now derived, they must be totaled
in order to get the total credit risk-adjusted assets that is required for the denominator in the computation
of the CAR.

International Requirements for Capital Adequacy Ratio

Under Basel II capital adequacy rules, a depository institution must hold a capital adequacy ratio greater
than or equal to 8% in order to be adequately capitalized. Furthermore, Tier I core capital component of
the total capital must be greater than or equal to 4%. In short, of the 8% capital adequacy ratio required,
a minimum of 4% is required by Basel II to be held in Tier 1 capital. The following expressions show the
capital adequacy ratio requirements:

In the light of Basel II, the countries that comply with these requirements have a stronger footing with
regard to being adequately capitalized and thus, avoiding insolvency, as opposed to the others.
However, there are also criticisms with regard to the Capital Adequacy Ratio. For instance, it is still
ambiguous how closely the five risk weights reflect the true credit risk inherent in a borrower.
Furthermore, the CAR largely ignores portfolio diversification opportunities by the depository institution.
It is possible to lower the risk that a depository institution faces through investing in loans and other
assets that arent correlated, i.e., diversification. There are more limitations that the CAR under Basel II
faces that Basel III hopes to improve on. Nevertheless, the CAR is an adequate measure to ensure stability
within the financial system.