Capital adequacy ratio

Also called: CAR, CRAR, Capital to risk-weighted assets ratio · Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT

Meaning

The Capital Adequacy Ratio (CAR), also called the Capital to Risk-weighted Assets Ratio (CRAR), is a bank's own capital (Tier 1 + Tier 2) shown as a percentage of its risk-weighted assets. Risk-weighted assets are the bank's assets, with riskier assets counted at a higher value.

CRAR = (Tier 1 capital + Tier 2 capital) ÷ Risk-weighted assets × 100

Capital is the owners' own money in the bank. When loans go bad, capital takes the loss first. Depositors lose money only after all the capital is gone. So a higher CRAR means the bank can absorb bigger losses before depositors are hurt.

Explanation

Why the ratio is needed: leverage

• Leverage means buying assets with borrowed money. For a bank, most of the borrowed money is deposits.
• Leverage makes profits bigger in good times.

• It also makes losses bigger in bad times.

• Example of leverage:

• A bank has Rs 100 of assets. Rs 92 comes from deposits and Rs 8 is its own capital.
• If 8% of the assets go bad (a Rs 8 loss), all the capital is wiped out. The bank is insolvent (it owes more than it owns).

• With Rs 12 of capital, the same loss leaves Rs 4, and the bank survives.

• Lesson: less capital means more leverage, so a smaller loss can bring the bank down. The CRAR puts a minimum on the capital a bank must hold.

The denominator: risk-weighted assets (RWA)

• RWA = each asset × its risk weight, added together. Safer assets need less capital behind them.
• Government securities (G-secs): 0% weight, because the government is not expected to default in its own currency.
• Home loans: the weight depends on the LTV band. LTV (loan-to-value) is the loan amount as a share of the house's value. A lower LTV gets a lower weight.

• Unsecured consumer credit (personal loans, credit cards): higher weights.

• Worked example:

Asset	Amount (Rs)	Risk weight	RWA (Rs)
G-secs	300	0%	0
Home loans	400	35%	140
Corporate loans	300	100%	300
Total	1,000		440

• Capital = Rs 50, so CRAR = 50 ÷ 440 ≈ 11.4%.
• This is above India's 9% minimum.
• It is just below 11.5%, which is the minimum once the capital conservation buffer is added. So this bank would face limits on paying dividends.
• Trap: capital ÷ total assets = 50 ÷ 1,000 = 5%. That is a different ratio, close to the leverage ratio. The CRAR always divides by risk-weighted assets.

The numerator: quality of capital (Tier 1 and Tier 2)

• Tier 1 capital is "going-concern" capital. It absorbs losses while the bank keeps running.
• Common Equity Tier 1 (CET1) is the best-quality capital. It includes common shares, share premium (money paid above the face value of shares), retained earnings (past profits kept in the bank) and disclosed reserves.

• Additional Tier 1 (AT1) instruments are perpetual (no maturity date) and non-cumulative (skipped interest is never paid later). They are written down or converted into equity if CET1 falls below a set trigger, or at the point of non-viability (PONV). PONV is when the regulator decides the bank cannot survive without help.

• Tier 2 capital is "gone-concern" capital. It absorbs losses mainly when the bank is wound up (liquidation). It includes:

• Subordinated debt, which is paid back only after depositors and other creditors
• General provisions, counted only up to 1.25% of credit RWA
• Revaluation reserves (gains from revaluing property), counted at a discount because their value is uncertain

How the rule evolved: Basel I to Basel III

• Basel norms are international standards for bank capital, liquidity and risk management. They are set by the Basel Committee on Banking Supervision (BCBS), which was set up in 1974 after the Herstatt Bank failure and is housed at the BIS, Basel. They are not legally binding. Each country makes them law through its own regulator.
• Basel I (1988): capital of at least 8% of RWA. It covered credit risk only, meaning the risk that a borrower does not repay. Risk weights were a few rough buckets from 0% to 100%.
• Basel II (2004): added market risk (losses from price, rate or currency moves) and operational risk (losses from fraud, system failure or human error). It also brought in three pillars:
• Pillar 1: minimum capital
• Pillar 2: supervisory review, through ICAAP (the bank's own check) and SREP (the RBI's check)

• Pillar 3: market discipline, through public disclosure

• Basel III (2010), after the 2008 crisis. Banks had held too little capital, of poor quality, with too much leverage. Basel III responded with:

• a higher share of CET1
• a capital conservation buffer (CCB) of 2.5% of RWA, held in CET1
• a countercyclical capital buffer (CCyB) of 0-2.5%

• a leverage ratio as a simple backstop

• What makes the CRAR rise or fall:

• It rises when banks raise fresh equity, keep profits inside the bank, or shift towards low-weight assets such as G-secs.
• It falls when NPA losses eat into capital, or when lending grows fast in high-weight loans such as MSME and unsecured loans.

In India

• Regulator: the RBI turns the Basel norms into binding rules and often sets stricter levels than Basel.
• History:
• India adopted Basel I in 1992, during the post-1991 reforms (Narasimham Committee-I era).
• It raised the minimum to 9% CRAR from 2000.

• It moved to Basel II in 2008-09.

• Basel III capital regulations took effect from 1 April 2013. Banks must meet the minimums on an ongoing basis. [1] The full phase-in came in October 2021, after several extensions, including during COVID-19.

Ratio	Basel III	India (RBI)
CET1	4.5%	5.5%
Tier 1	6%	7%
Total CRAR	8%	9%
CCB (in CET1)	2.5%	2.5%
CET1 + CCB	7%	8%
Total + CCB	10.5%	11.5%
Leverage ratio	3%	4% (D-SIBs), 3.5% (others)

• The minimum Pillar 1 CRAR is 9%, not counting the CCB and CCyB. Tier 1 must be at least 7% of RWA on an ongoing basis. [1]
• Why India sets stricter levels:
• PSBs have a history of high NPAs.

• Loans are often concentrated in a few sectors or companies.

• CCyB: the RBI framework dates from 2015. In April 2022 the RBI said it was not necessary to activate the CCyB at that time. [2]

• Latest figures for scheduled commercial banks (SCBs):
• CRAR rose from 12.94% (March 2015) to 17.36% (March 2025). [4]
• CET1 rose from 9.98% to 14.81% over the same period. [4]

• Both are well above the 11.5% and 8% minimums that include the CCB.

• Stress tests are the RBI's simulations of a bad economy. In them, SCBs' capital stays above the regulatory minimum even in adverse scenarios (Financial Stability Report, June 2026). [3]

• Why capital improved:
• government recapitalisation of PSBs
• NPA clean-up after the Asset Quality Review (2015) and the IBC (2016)
• higher profits kept inside the banks

Don't confuse with

• Leverage ratio: Tier 1 capital ÷ total exposure, with no risk weights. The CRAR uses total capital (Tier 1 + Tier 2) ÷ risk-weighted assets. The leverage ratio is a backstop for when banks game their risk weights.
• CRR / SLR: these are about liquidity. They set how much of a bank's deposits it must keep as cash with the RBI or in safe liquid assets. The CRAR is about solvency: the owners' capital measured against risky assets.
• Capital conservation buffer (CCB): this is not part of the 9% minimum CRAR. It is an extra 2.5% held in CET1 only. Breaching it limits dividends. It does not shut the bank.
• Tier 1 vs Tier 2: AT1 bonds are Tier 1. General provisions are Tier 2 (up to 1.25% of credit RWA), not Tier 1.

Prelims Hooks

• CRAR = (Tier 1 + Tier 2) ÷ Risk-weighted assets × 100. The leverage ratio = Tier 1 ÷ total exposure (no risk weights).
• BCBS: set up in 1974 after the Herstatt Bank failure. Housed at the BIS, Basel. India has been a member since 2009. Basel norms are not a treaty and are not legally binding.
• Basel I (1988): 8% of RWA, credit risk only. India adopted it in 1992 and moved to 9% from 2000. Operational risk first came with Basel II.
• India's Basel III minimums: CET1 5.5%, Tier 1 7%, CRAR 9%. With the CCB: 8% / 11.5%. These took effect from 1 April 2013. [1]
• CCyB: 0-2.5%. Its main indicator is the credit-to-GDP gap, meaning how far the credit-to-GDP ratio is above its long-term trend. The RBI said in April 2022 that it was not necessary to activate it. [2]
• SCB CRAR was 17.36% and CET1 was 14.81% (March 2025). [4]

Mains Points

• Safety vs growth: India's stricter-than-Basel norms (9% vs 8%, CET1 5.5% vs 4.5%) protect depositors in a system with a history of NPAs. But higher capital also makes lending costlier.
• Equity costs a bank more than deposits.
• High-weight loans (MSME, unsecured) need more capital.
• In 2017-18, several capital-short PSBs were under Prompt Corrective Action (PCA), the RBI's framework of restrictions on weak banks, and credit to MSMEs was squeezed.

• A good answer weighs the fiscal cost of recapitalisation against the growth cost of tight credit.

• No single ratio is enough: in 2008, banks' own models showed low risk weights, so they held too little capital. This led to the leverage ratio and the output floor (Basel III final reforms, 2017).

• Stability needs capital, liquidity (LCR/NSFR), supervision (Pillar 2) and disclosure (Pillar 3) working together.

• It is also worth asking whether the credit-to-GDP gap, the CCyB's main indicator, suits a fast-growing, under-banked India. Here credit rises naturally as more people and firms get access to banks. [2]

• Capital + resolution = stability: a strong CRAR (17.36%, March 2025) [4] and good stress test results [3] rest on NPA recognition (AQR 2015) and resolution (IBC 2016).

• Capital absorbs the losses.
• Resolution removes the bad assets.
• Neither works alone.

Related concepts

• Leverage
• Basel norms
• Basel I
• Basel II
• Three pillars of Basel
• Risk-weighted assets
• Tier 1 capital
• Common Equity Tier 1
• Additional Tier 1 capital
• Tier 2 capital

Read more

• Capital adequacy: Basel I to Basel III