Capital Adequacy Ratio (CAR)
The CAR Formula
The numerator is total regulatory capital: Tier 1 capital (common equity, retained earnings) plus Tier 2 capital (subordinated debt, loan-loss reserves). The denominator is risk-weighted assets (RWA) — the bank’s assets adjusted for credit risk. A government bond might carry a 0% risk weight, while an unsecured consumer loan might carry 100%.
Basel III Capital Requirements
| Requirement | Minimum Ratio | What It Measures |
|---|---|---|
| Common Equity Tier 1 (CET1) | 4.5% | Highest-quality capital (common shares + retained earnings) |
| Tier 1 Capital Ratio | 6.0% | CET1 + Additional Tier 1 (e.g., preferred shares) |
| Total CAR | 8.0% | Tier 1 + Tier 2 capital |
| Capital Conservation Buffer | +2.5% | Extra cushion above minimum (restricts dividends if breached) |
| Effective Minimum (with buffer) | 10.5% | Total requirement for unrestricted operations |
How to Calculate CAR: Example
Suppose a bank has $50 billion in Tier 1 capital, $10 billion in Tier 2 capital, and $500 billion in risk-weighted assets:
At 12%, this bank comfortably exceeds the 10.5% effective minimum. It can pay dividends, buy back shares, and continue lending without regulatory restriction.
What Risk-Weighted Assets Mean
Not all bank assets carry the same risk. Risk weighting adjusts the denominator so that riskier portfolios require more capital. This is a central concept in Basel III.
| Asset Type | Typical Risk Weight | Example |
|---|---|---|
| Government Bonds (AAA) | 0% | U.S. Treasuries |
| Interbank Loans | 20% | Loans to other banks |
| Residential Mortgages | 35–50% | Home loans |
| Corporate Loans | 100% | Business lending |
| Unsecured Consumer Loans | 100–150% | Credit cards, personal loans |
Why CAR Matters for Investors
A strong CAR signals resilience. Banks with higher ratios can weather economic downturns, continue lending during a recession, and are less likely to need emergency capital raises that dilute shareholders. During stress tests, regulators project how a bank’s CAR would change under severe scenarios — a bank that falls below minimums must take corrective action.
Watch out for banks that barely clear the minimum. If non-performing loans spike or the bank takes large write-downs, a thin capital cushion can evaporate fast.
Key Takeaways
- The capital adequacy ratio measures total capital (Tier 1 + Tier 2) relative to risk-weighted assets.
- Basel III sets the minimum at 8%, but the effective floor with buffers is 10.5%.
- Risk weighting means riskier loan portfolios require more capital backing.
- CET1 ratio is the most important sub-metric — it captures the highest-quality capital.
- A falling CAR is a red flag that may signal rising non-performing loans or deteriorating asset quality.
Frequently Asked Questions
What is a good capital adequacy ratio?
Most well-capitalized banks carry a CAR between 12% and 18%. The regulatory minimum under Basel III is 8% (10.5% with the conservation buffer), but banks operating near the floor face restrictions on dividends and buybacks. Higher is generally better for safety, though extremely high ratios can suggest the bank isn’t deploying capital efficiently.
What happens if a bank’s CAR falls below 8%?
Regulators intervene. The bank may be barred from paying dividends, forced to raise new capital, required to sell assets, or placed under enhanced supervisory review. In extreme cases, the FDIC may step in to manage an orderly resolution.
How is CAR different from the Tier 1 ratio?
The Tier 1 ratio only counts Tier 1 capital in the numerator. CAR counts total capital (Tier 1 + Tier 2). The Tier 1 ratio is a stricter measure because it excludes supplementary capital like subordinated debt.
Do all banks use the same risk weights?
Not exactly. Basel III provides standardized risk weights, but large banks using the Internal Ratings-Based (IRB) approach can calculate their own risk weights based on internal models — subject to regulatory approval. This means two banks with identical loan portfolios might report different risk-weighted assets.
How often do banks report their capital adequacy ratio?
U.S. banks report CAR quarterly in their regulatory filings (Call Reports for banks, FR Y-9C for bank holding companies). Publicly traded banks also disclose capital ratios in their quarterly earnings reports and 10-Q filings.