Capital Adequacy Ratio - CAR

Just like we need an adequate supply of capital in our normal lives (you know, cash to pay our bills, etc.), banks need to have an adequate supply in order to make loans and pay out interest to their customers. It's also rather important to have cash on hand when a customer wants to withdraw money from their account (Think: It's A Wonderful Life).

The capital adequacy ratio (CAR) is a key metric for banks. It measures the amount of available capital as a percentage of risk-weighted credit exposure (in other words, risky loans). The figure is used to protect depositors and ensure the viability of the banking system.

The ratios measure two types of capital: Tier 1 and Tier 2 (sounds like a Dr. Seuss book). Tier 1 capital is the type that is easily available and can absorb losses without the bank having to cease operating. Tier 2 capital can cushion losses if the bank is in the process of closing (winding up) and all the Tier 1 capital is gone.

To calculate the CAR, simply add Tier 1 and Tier 2 capital and divide by "risk weighted assets" (the bank's assets such as outstanding loans weighted according to risk.) This helps auditors check to see if there will be enough cash on hand so customer deposits are not lost if the bank fails. The higher the ratio, the safer a customer's deposits will be, while the minimum ratio that banks must maintain is only 8%.