Capital To Risk Weighted Assets Ratio(CRAR)

The CRAR is the capital needed for a bank measured in terms of the assets (mostly loans) disbursed by the banks. Higher the assets, higher should be the capital by the bank

A notable feature of CRAR is that it measures capital adequacy in terms of the riskiness of the assets or loans given. For example, if the bank has given loans to the government by investing in government securities like government bonds, it need not keep any capital. This is because, the riskiness of loans to government securities is zero and hence, the risk weight for government securities is zero

But in the case of risky assets like loans to the real estate sector, the risk weight will be higher- for example 300 %. Here, if the CRAR is 9 % (for standard assets with a risk weight of 100%); a bank should keep Rs 27 for giving Rs 100 loans to the real estate sector

What is Tier I and Teir 2 capital?

Capital is classified in terms of its degree of contribution from  the owners (share holders). Tier 1 Capital is more equity capital or it is provided by the most responsible people of the bank – its share holders. Hence, most of the tier 1 capital will be in the form of equities. On the other hand, tier 2 capital is more in the form of reserves, debts etc

Tier 1 Capital: is the core measure of a bank’s financial strength from a regulator’s point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock

Tier 2 Capital: represents “supplementary capital” such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt of the financial institution.

The formula to calculate a bank's capital adequacy ratio is the bank's tier-one capital, plus its tier-two capital divided by the risk-weighted assets

The capital-to-risk-weighted assets ratio for a bank is usually expressed as a percentage. The current minimum of the total capital to risk-weighted assets, under Basel III, is 10.5%. Having a global standard promotes the stability and efficiency of worldwide financial systems and banks.

Capital-To-Risk-Weighted Assets Ratio Example

For example, assume bank ABC has tier one capital of $10 million and tier two capital of $5 million. It has $400 million in risk-weighted assets. The resulting capital to risk-weighted assets ratio is 3.75%:

$\text{Capital-to-risk weighted assets} = \frac{\$10 \text{MM} + \$5 \text{MM}} {\$400 \text{MM}} \times 100\%$

With a ratio significantly below 10.5%, bank ABC has not met the minimum requirement of capital risk-weighted assets. The bank is holding too much in risk-weighted assets, in comparison with its tier-one and tier-two capital.

On the other hand, assume bank DEF has tier-one capital of $15 million, tier-two capital of $10 million, and $75 million in risk-weighted assets. Bank DEF's resulting capital to risk-weighted assets ratio is 33%:

$\text{Capital-to-risk weighted assets} = \frac{\$15 \text{MM} + \$10 \text{MM}} {\$75 \text{MM}} \times 100\%$

$Therefore,\; bank\; DEF\; is\; financially\; stable,\; likely\; to\; be\; able\; to\; absorb\; its\; losses$