The Capital Adequacy Ratio (CAR) is calculated by dividing the sum of a bank's Tier 1 and Tier 2 capital by its Risk-Weighted Assets (RWA). This method aligns with Basel II guidelines, which emphasize the importance of weighting assets by their respective risk levels. The approach ensures that the bank's available capital is sufficient to cover potential losses arising from its risk exposures. The ratio serves as a crucial indicator of the bank's financial health, its ability to withstand potential losses, and its capacity to meet obligations.

A is incorrect because simply dividing the total capital by total assets does not account for the varying risk profiles of different assets. Basel II requires the use of RWAs for a more accurate assessment of risk exposure.

C is incorrect because the formula described reverses the correct calculation method. It incorrectly suggests dividing the aggregated risk weights by capital, which does not align with the established practices for CAR calculation.

D is incorrect because it suggests an incorrect formula that involves subtracting Tier 2 capital from Tier 1 and dividing by total liabilities. This does not conform to any standard method for calculating CAR and does not factor in the risk weight of assets.

Things to Remember

• CAR calculation must consider the risk profile of each asset, assigning appropriate weights based on the likelihood of default or other risk factors.
• Tier 1 capital, being the core capital, includes equity capital and disclosed reserves. Tier 2 capital comprises supplementary capital elements like subordinated debts.
• Adhering to Basel II guidelines, banks must maintain a minimum CAR to ensure financial stability and readiness for unexpected losses.