Understanding Capital Adequacy
We all know that Capital refers to the assets which are capable of generating income and which have themselves been produced. This is one of the four factors of production and consists of Machine, Plant and Building, Land and Labour.
But in Banking Industry, Capital refers to the stock of Financial Assets which is capable of generating income.
The Capital Adequacy Ratio is a thermometer of Bank's health, because it is the ratio of its capital to its risk.
So simply, Capital Adequacy Ratio = Capital ÷Risk
So, the Capital Adequacy can indicate the capacity of the Bank's ability to absorb the possible losses.
The Regulators check CAR to monitor the health of the Bank, because a good CAR protects the depositors and maintains the faith and confidence in the banking system.