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%.
Related or Semi-related Video
Finance: What is working capital?268 Views
finance a la shmoop. what is working capital? alright people say we're opening
a lemonade stand. I seed what you did there. unfortunately we can't just blink [man stands in front of stage]
our eyes like Aladdin's genie and you know make it all happen. magically we
don't need a ton of money to start things but we need some money in advance. [genie comes out of lamp]
of you know when we begin collecting revenues well we have to rent a location,
and pay six months rent in advance, and we got to buy about 87 pounds of
sugar and 4,000 lemons and hundred fourteen huge bottles of purified water,
oh and cups we need eight thousand cups. all told it costs about 50 grand in
capital, working capital. see we did there, we need before we can start to run the
business, and you know pay employees and so on .so we get an investor TBOG. the [people stand in line for lemonade]
bank of Grandma. yeah we love her. she gives us a hundred grand. well that
entire hundred grand invested into our little business is our total working
capital. right? fifty grand and start the business working and we got 50 left over
or just in case things don't start up as quick as we hope .its capital that lets
us start working. in cleverly named there. all right well 50 grand we know we're
gonna spend 50 grand and cover the time in between when we're up and running and [calendar]
revenues and all the other stuff start to kick in. and well yeah it's that
simple. put together an actual drinkable lemonade recipe ?well that's just a
little bit harder. working capital. live it love it breathe it. [ grandma grimaces]
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