Previous Year Question
Consider the following statements:
Capital Adequacy Ratio is the amount that banks have to maintain in the form of their own funds to offset any loss that banks incur if the account holders fail to repay any dues.
Capital Adequacy Ratio is decided by each individual bank.
Which of the statements given above is/are correct?
1 only
2 only
Both 1 and 2
Neither 1 nor 2
Correct Answer: A
Detailed Solution
The Capital Adequacy Ratio, or CAR, is also described in the RBI’s banking-regulation framework as the Capital to Risk-Weighted Assets Ratio, or CRAR.
It represents the relationship between a bank’s available regulatory capital and its risk-weighted assets:
Statement 1 is correct.
Banks primarily use funds received from depositors and other creditors for lending and investment. If some borrowers fail to repay their loans, or the bank incurs losses from market, operational or other risks, the bank’s own capital acts as the initial loss-absorbing buffer.
Adequate capital is intended to:
provide the capacity to absorb unexpected losses;
protect the interests of depositors and other creditors;
preserve the bank’s solvency and financial stability; and
ensure that the bank maintains minimum own funds corresponding to the risk of its assets.
Different assets receive different risk weights according to their level of risk. Therefore, every ₹100 bank exposure does not have an identical impact on CAR. A secured government security and an inadequately secured commercial loan, for example, do not carry the same credit risk.
Statement 2 is incorrect.
Banks do not independently determine their minimum CAR. The RBI prescribes minimum capital-adequacy requirements after considering the Basel standards and Indian banking conditions.
Based on a bank’s size, business model, risk profile and supervisory assessment, the RBI may also require it to maintain capital above the ordinarily applicable minimum. A bank may internally target a higher CAR as a matter of prudence, but it cannot independently prescribe a level below the regulatory minimum established by the RBI.
Regulatory capital for CAR purposes principally includes:
Common Equity Tier 1 capital;
Additional Tier 1 capital; and
Tier 2 capital.
These capital components provide protection against credit, market and operational risks.