[Economy Q] Capital Adequecy ratio

[Economy Q] Capital Adequecy ratio

Nitro asked,

What is capital adequacy ratio ?

 

Answer

 

Banks give loans to people. But if majority of the people default on their loans, and bank doesn't have enough cash to pay back to its depositors, fixed deposit account holders, employee's salary, monthly electricity bill, building rent etc. In that case bank's assets will have to be liquidated (i.e. auction) to payback all those people, and the bank will close down.

 

To prevent such disaster, banks are required to maintain Capital adequacy ratio (CAR). Beyond which they shouldn't give loans or get involved in any other risky business. So even if they get in trouble, they've enough money to payback all its liabilities.

 

For example, If bank has 100 cr. worth capital, then it should not give loans of more than 10 cr.

 

Capital adequacy ratios (CAR) = bank's capital (like cash, building, bonds etc) divided by bank's risky assets (like loans given)

Generally it should not be more than 10% according to BASEL norms.