Economy Simplified: Capital Adequacy Ratio (CRAR) and Basel Norms explained.

Capital Adequacy Ratio

1. Capital adequacy ratio (CAR) is the ratio of a bank’s available capital, in relation to the risks involved in terms of loan disbursement.  In other words, capital adequacy ratio is the ratio of a bank’s capital in relation to its assets and liabilities.
2. Capital Adequacy Ratio (CAR) is the measurement ratio that assesses the ability of banks to absorb losses.
3. It standardizes the banks’ abilities to pay off its liabilities, tackle credit and operational risks
4. CAR measures the ratio of two tiers of capitals: tier 1 capital that absorbs the risks during the working of the bank, and tier 2 capital that absorbs losses during its liquidation so as to provide necessary compensation to the customers of the bank.
5. The formula for CAR is: (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets.

Basel Accord

1. The Basel accord is a comprehensive set of reform measures aimed to strengthen the regulation, supervision and risk management of the banking sector.
2. The Basel Accords (i.e. Basel I, II and now III) are a broader and inclusive set of agreements set by the Basel Committee on Bank Supervision (BCBS).
3. The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters for the central banks of different countries.
4. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
Basel 1 (1988)It focused almost entirely on credit risk.
CRAR – 8% by BIS (Bureau for International Settlements) but 9% by RBI.
India adopted Basel 1 guidelines in 1999
Basel 2 (2004)Focus on these three pillars – minimum capital requirements, supervisory review and market discipline.
8%by BIS and 9% by RBI as minimum CRAR.
India Adopted in 2009 and was fully implemented by 2015
Basel 3 (2010)The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
Focus on  3 pillars: 1. Improve the banking sector’s ability to absorb shocks arising from financial and economic stress, 2. Improve risk management and governance and 3. Strengthen banks’ transparency and disclosures.
Stipulated a Capital to Risk-weighted assets (CRAR) of 8%.

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