What is Capital Adequacy Ratio (CAR)?
- Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities.
- It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
- It is measured as:
Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets
- The risk weighted assets take into account credit risk, market risk and operational risk.
- The Basel III norms stipulated a capital to risk weighted assets of 8%.
- However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12%.
About Basel Norms
- Basel is a city in Switzerland which is also the headquarters of Bureau of International Settlement (BIS).
- BIS fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations.
- Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the Basel Committee on Banking Supervision (BCBS).
- The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord.
- The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
- India has accepted Basel accords for the banking system.
- The Basel Committee makes these norms but the committee’s decisions have no legal force.
- The Committee formulates supervisory standards and guidelines and recommends statements of best practice in the expectation that individual national authorities will implement them.
- In this way, the Committee encourages convergence towards common standards and monitors their implementation, but without attempting detailed harmonisation of member countries’ supervisory approaches.
Reasons for high capital requirement: RBI
- According to RBI, prudential capital regulations aim to enable banks to sustain unexpected losses without defaulting on its obligations, especially deposits, by maintaining adequate levels of bank capital.
- Further, higher levels of capital increases the skin in the game for shareholders, thus potentially leading to better credit appraisal and screening.
- Banks in India remain one of the most under-provisioned ones, though there has been an improvement in this regard in the last few quarters. As the equity component in a bank goes up, the leverage goes down, and make banks safer.
- The current levels of provisions maintained by banks may not be enough to cover the expected losses, so there is a need to build adequate buffers to absorb the expected losses.
- To make sure that the banking system is resilient enough to support higher credit growth going forward, it should have higher capital levels
- Higher capital requirement leads to lower credit growth is ‘mathematically correct’ but cited data to show credit growth in the economy is in line with nominal GDP growth. High levels of credit growth due to ‘supply push’ have resulted in high corporate leverage and consequent NPAs in the banking system.
- RBI also clarified on the ‘oft repeated view’ that public sector banks need not be subject to prudential capital regulations as they are owned by the sovereign.
- Any slackening of the prudential norms may result in a reset of their credibility/standing in the international markets. Such a reset could increase the cost and ease of doing business for their clientele and their clientele may need to migrate to other banks which are compliant with Basel standards.