The capital adequacy ratio is a financial benchmark used to measure a bank’s capital and sometimes applied to other businesses to assess the adequacy of the organization’s capital to protect investors from risk. The formula used to measure CAR is complicated and relies on a fairly detailed knowledge of accounting, but the essence of CAR is that it divides capital by risk-weighted assets. The higher the resulting ratio, the better.
Capital in the CAR formula is divided into two kinds: Tier 1 and Tier 2. Tier 1 is the bank’s capital that can absorb loss without causing the bank to have to cease trading. Tier 2 is the last-ditch capital: the capital that can be used to absorb losses in the event that the bank is forced to close. Risk-weighted assets are a measure of the riskiness of a bank’s assets (generally in terms of its investments).
The Bank for International Settlements (BIS) in Basel, Switzerland, has set standards for the CAR that have been adopted by the U.S. and other countries.