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Definition: Capacity Adequacy Ratio
Capacity adequacy ratio (CAR) is a ratio which measures how much capital is used to support the bank`s risk assets. It is used to ensure that the bank is able to handle losses and still fulfill its obligations to the depositors without ceasing the operations of the bank. It is one ratio which has keenly been used by regulators so as to have an idea about the financial health of the bank. CAR determines the capacity of a bank in meeting the liabilities and different types of risk. These can be credit risk, operational risk, marketing risk or other types of risk. CAR establishes a relationship between bank`s capital and bank`s risk. The ratio can be calculated by dividing bank`s current capital against current risks. Bank’s capital is used to cover potential losses, which protect the investors or other lenders.
CAR can be calculated using the following formula,
Capital adequacy ratio = (Tier 1 capital + Tier 2 capital)/risk weighted assets
Here capital of the bank has been classified in two tiers based on degree of protection it provides to depositors. Tier 1 capital provides more protection to the depositors and can absorb losses while trading whereas tier 2 capital provides less protection to the depositors and can absorb losses only at the time of winding up. The minimum value of CAR that a bank has to maintain varies from country to country and is often determined by the national banking regulator of the respective countries.