'Capital Adequacy Ratio - CAR'

The Capital Adequacy Ratio (CAR) is a measure of a bank's available capital expressed as a
percentage of a bank's risk-weighted credit exposures.

The Capital Adequacy Ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used
to protect depositors and promote the stability and efficiency of financial systems around the
world.

Two types of capital are measured: tier one capital, which can absorb losses without a bank
being required to cease trading, and tier two capital, which can absorb losses in the event of a
winding-up and so provides a lesser degree of protection to depositors.

CAR= Total Capital (Tier1+ Tier2 capital) x 100

RWA

Tier 1 Capital (Core capital): Tier one capital is the capital that is permanently and
easily available to cushion losses suffered by a bank without it being required to stop operating.
A good example of a bank’s tier one capital is its ordinary share capital.

Tier 1 capital is the core measure of the financial strength of a bank because it is composed of
core capital.

Core Capital: Core capital is composed primarily of disclosed reserves (also known as retained
earnings) and common stock. It can also include noncumulative, nonredeemable preferred stock.
Under the Basel Committee on Banking Supervision, which issued the Basel Accord, it was
observed that banks utilize inventive instruments to accumulate Tier 1 capital as well.

However, such instruments must adhere to strict conditions. Capital acquired through these
instruments can only account for 15% of the bank’s total Tier 1 capital. The third Basel Accord,
its first version issued in 2009, is scheduled to do away with capital earned through innovative
instruments. Changes were made to the accord in 2013. The implementation date of the final
version of the third accord has been moved to the end of March 2019.

Tier 2 Capital (Supplementary capital): Tier two capital is the one that
cushions losses in case the bank is winding up, so it provides a lesser degree of protection to
depositors and creditors. It is used to absorb losses if a bank loses all its tier one capital.
It includes: 1. Undisclosed reserves
2. Revaluation reserve
3. General provisions/general loan-loss reserves
4. Hybrid debt capital instruments
5. Subordinated term debt
Tier 2 capital is the secondary component of bank capital, in addition to Tier 1 capital, that
makes up a bank's required reserves. Tier 2 capital is designated as supplementary capital, and is
composed of items such as revaluation reserves, undisclosed reserves, hybrid instruments and
subordinated term debt. In the calculation of a bank's reserve requirements, Tier 2 capital is
considered less secure than Tier 1 capital, and in the United States, the overall bank capital
requirement is partially based on the weighted risk of a bank's assets

The first component of Tier 2 capital is revaluation reserves, which are reserves created by the
revaluation of an asset. A typical revaluation reserve is a building owned by a bank. Over time,
the value of the real estate asset tends to increase and can thus be revalued.

The second component is general provisions. These are losses a bank may have of an as yet
undetermined amount. The total general provision amount allowed is 1.25% of the bank's risk-
weighted assets (RWA).

The third element is hybrid capital instruments, which have mixed characteristics of both debt
and equity instruments. Preferred stock is an example of hybrid instruments. A bank may include
hybrid instruments in its Tier 2 capital as long as the assets are sufficiently similar to equity so
losses can be taken on the face value of the instrument without triggering liquidation of the bank.

The final component of Tier 2 capital under U.S. regulations is subordinated term debt with a
minimum original term of five years or more. The debt is subordinated in regard to ordinary
bank depositors and other loans and securities that constitute higher-ranking senior debt.

Tier 3 Capital (Short-term subordinated debt covering market

risk): Tier 3 capital is tertiary capital, which many banks hold in order to support their market
risk, commodities risk, and foreign currency risk. Tier 3 capital includes a greater variety of debt
than tier 1 and tier 2 capitals

Tier 3 capital consists of Tier 2 capital plus short-term subordinated loans