What is Capital to Risky Asset Ratio (CRAR)?
One of the leading outcomes of the financial sector crisis of 2007 is that financial regulators or central banks are coming out with strict regulation of financial institutions. They found that the best way to ensure non failure of financial institutions including commercial banks is to put more capital into these institutions.
Thus, the central banks are instructing the banks to increase capital by the share holders. More the capital put by the shareholders or owners of banks, the more will be the capability of the banks to overcome a crisis on its own. Similarly, if the share holders are injecting more money, the bank will not take any risks, as it may result in more loss of money of the shareholders; in the case of a bank failure.
This means that a situation of government or the central bank coming for the rescue of a failing bank by giving fund to it doesn’t arise. In this way, capital enhancement became the core policy of many new financial sector regulation measures including Basel III.
Now, how much capital is to be put into a bank?
Here comes the concept of capital adequacy ratio (CAR) or capital to risk weighted asset ratio (CRAR). The CRAR is the capital needed for a bank measured in terms of the assets (mostly loans) disbursed by the banks. Higher the assets, higher should be the capital by the bank.
A notable feature of CRAR is that it measures capital adequacy in terms of the riskiness of the assets or loans given. For example, if the bank has given loans to the government by investing in government securities like government bonds, it need not keep any capital. This is because, the riskiness of loans to government securities is zero and hence, the risk weight for government securities is zero.
But in the case of risky assets like loans to the real estate sector, the risk weight will be higher- for example 300 %. Here, if the CRAR is 9 % (for standard assets with a risk weight of 100%); a bank should keep Rs 27 for giving Rs 100 loans to the real estate sector.
What is Tier I and Teir 2 capital?
Capital is classified in terms of its degree of contribution from the owners (share holders). Tier 1 Capital is more equity capital or it is provided by the most responsible people of the bank – its share holders. Hence, most of the tier 1 capital will be in the form of equities. On the other hand, tier 2 capital is more in the form of reserves, debts etc.
Tier 1 Capital: is the core measure of a bank’s financial strength from a regulator’s point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock.
Tier 2 Capital: represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt of the financial institution.
The idea is simple, if you are managing huge money in the form of loans given, you should put more money into your bank. Such a deployment of money will make you more responsible while you give loans (because loans are financed out of deposits, if loans are not coming back, the depositors should not suffer).