What is capital adequacy framework?

Adequate capital is required by banks to absorb any losses that arise during the normal course of the bank’s operations. Each Capital contribution/Equity contribution is a contribution of capital, in the form of money or property, to a business by an owner, partner, or shareholder.  The capital adequacy frame work in banking business emphasizes adequate resource to absorb any losses arising from the risks in its business. The Capital is divided into different tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories viz. Tier I and Tier II.

The Basel Norms for regulating Bank’s capital requirement for managing credit risk use the concept of risk-weighted assets to determine a bank’s minimum capital needs. In this system, the funded and non-funded items and other off-balance sheet exposures are assigned weights according to the risk perception and banks are required to maintain unimpaired minimum capital funds to the prescribed ratio on the risk weighted assets. The  notional amount of the each asset is  multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number. Risk weight for different assets vary e.g. 0% on a Government Dated Security and 20% on an AAA rated foreign bank etc.

Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank’s capital to its risk.. The Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the CRAR of a bank the better capitalized it is.Tier 1 CRAR =( Eligible Tier 1 capital funds)= (Credit Risk RWA + Market Risk RWA + Operational Risk RWA)
Total CRAR= (Eligible Total capital funds)÷ (Credit Risk RWA + Market Risk RWA + Operational Risk RWA)