Q. Consider the following statements: - Capital Adequacy Ratio (CAR) 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 dues.
- CAR is decided by each individual bank.
Which of the statements given above is/are correct? (UPSC Prelims 2018)
Answer:
1 only
Notes: The correct answer is
[A] 1 only. The
Capital Adequacy Ratio (CAR), also known as Capital to Risk-weighted Assets Ratio (CRAR), is a critical measure used to protect depositors and promote stability in the financial system.
- Definition and Purpose (Statement 1 – Correct): CAR is the ratio of a bank's capital to its risk-weighted assets and current liabilities. It acts as a financial cushion or "buffer" that banks must maintain using their own funds. This ensures the bank can absorb a reasonable amount of loss if borrowers default on their loans (NPAs) before they become insolvent and lose depositors' money.
- Regulatory Authority (Statement 2 – Incorrect): CAR is not decided by individual banks. It is regulated by the Central Bank of the country (the Reserve Bank of India in India) based on international standards known as the Basel Accords. While the Basel III norms suggest a minimum CAR of 8%, the RBI typically mandates a slightly higher requirement (currently 9% for public sector banks) to ensure a higher safety margin.
Key Components of CAR:
- Tier 1 Capital: Core capital, including equity capital and disclosed reserves, which can absorb losses without a bank being required to cease trading.
- Tier 2 Capital: Supplementary capital, such as revaluation reserves and subordinated debt, which is less secure.
- Risk-Weighted Assets: Assets (loans) weighted by their risk level. For example, a loan secured by government bonds has a lower risk weight than an unsecured personal loan.