Question map
Consider the following statements : 1. Capital Adequacy Ratio (CAR) is the amount that banks have to maintain in the form of their own funds to offset any loss that banks incur if the account-holders fail to repay dues. 2. CAR is decided by each individual bank. Which of the statements given above is/are correct ?
Explanation
The correct answer is option A (Statement 1 only).
**Statement 1 is correct:** CRAR is defined as the proportion of bank's total risk-weighted assets that are held in the form of shareholders' equity and certain other defined class of capital.[1] This capital serves as a buffer to offset losses when account-holders fail to repay dues. Higher the capital to risk weighted asset ratio (CRAR), higher is the safety of bank deposits.[2]
**Statement 2 is incorrect:** CAR is not decided by individual banks but is prescribed by regulatory authorities. It prescribed minimum capital requirement at 8 per cent of the Risk Weighted Assets (RWA) for banks.[1] In India's context, Under Basel-I, the RBI issued guidelines to maintain a CRAR (Capital to Risk Assets Ratio) or CAR (Capital Adequacy Ratio) of 9 per cent by every SCB.[1] This clearly shows that the central bank (RBI), not individual banks, sets the CAR requirement based on international Basel norms.
Sources- [1] Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-I Norms > p. 234
- [2] Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2 Money and Banking- Part I > p. 94
PROVENANCE & STUDY PATTERN
Full viewThis is a classic 'Definition + Authority' trap. Statement 1 is a standard textbook definition found in every Banking chapter. Statement 2 tests your common sense on regulation: if banks set their own safety limits, the entire concept of 'regulation' collapses. This is a Sitter for anyone who has covered Basel Norms.
This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.
- Statement 1: Is Capital Adequacy Ratio (CAR) the amount of a bank's own funds that must be maintained to absorb losses arising from borrowers' defaults or non-repayment?
- Statement 2: Is the required Capital Adequacy Ratio (CAR) decided by each individual bank rather than being prescribed by banking regulators (e.g., the central bank or Basel standards)?
- Gives a formal definition of CRAR/CAR as the proportion of a bank's capital (shareholders' equity and defined capital) relative to risk-weighted assets — i.e., CAR is held in the form of a bank's own funds.
- Links the capital held to risk-bearing capacity by measuring it against risk-weighted assets, which implies its role in covering potential credit losses.
- Explains that when loans turn bad (NPAs) banks make provisions that erode bank capital, indicating that bank capital functions as a buffer against loan losses.
- Notes that erosion of capital constrains lending, showing capital's practical role in absorbing losses from defaults.
- Illustrates CRAR computation using risk weights and ties a higher CRAR to greater depositor safety, reinforcing that capital cushions against risky/ non‑performing assets.
- Shows the concept of risk-weighted assets used in CRAR, connecting the capital held to the risk of borrower defaults.
- Explicitly names a regulator-established guideline (OSFI) for capital adequacy requirements.
- Shows a prescribed formula for CAR (Capital Base / Total Risk Weighted Assets), indicating it is defined by reporting rules rather than each bank choosing it.
- States that the aggregate bank CAR is based on Basel III rules, linking CAR to internationally prescribed regulatory standards.
- Indicates CAR is driven by externally defined Basel standards rather than individual bank discretion.
- Refers to 'higher capital ... constraints' imposed through regulatory reforms after the global financial crisis.
- Implies capital requirements are regulatory constraints placed on banks, not freely chosen by each bank.
Explicitly states Basel-I prescribed a minimum capital requirement (8% RWA) and that RBI issued guidelines to maintain a CRAR/CAR of 9% by every Scheduled Commercial Bank — showing regulators set minima.
A student could infer that since RBI issued a uniform guideline for all banks, CAR is regulator-prescribed rather than individually chosen; they could check other central bank circulars or bank-level disclosures to confirm.
Describes 'Capital Adequacy Requirements' as a pillar of Basel norms, requiring banks to maintain a minimum (8%) and mandating disclosure of CAR to the central bank — implies external prescription and oversight.
Combine this with knowledge that Basel standards are implemented by national regulators to conclude CAR is set by regulatory frameworks and then enforced locally.
Lists Basel-III operational requirements (Tier I ratio, conservation buffer, counter-cyclical buffer) and a total CRAR target — these are specific, externally defined percentages banks must hold.
A student could use this pattern to check that such detailed percentage requirements are defined by international/local regulators rather than by individual banks.
States banks have achieved minimum Basel III capital requirements and that falling below the regulatory minimum restricts lending — indicating mandatory regulatory minima with consequences.
Extend by noting that if regulators impose consequences for falling below a minimum, banks cannot freely choose CAR without facing restrictions.
Explains Basel (BIS) fosters co-operation among central banks and sets common standards of banking regulations — suggesting CAR originates from such international/regulatory standards.
A student could link the role of BIS and central banks to infer CAR is part of externally set regulatory standards implemented nationally.
- [THE VERDICT]: Sitter. Directly covered in standard sources like Vivek Singh (Ch: Money & Banking) or Nitin Singhania (Ch: Financial Market).
- [THE CONCEPTUAL TRIGGER]: Banking Regulation & Basel Norms (Global Standards vs Indian Implementation).
- [THE HORIZONTAL EXPANSION]: Memorize the Basel III Trinity: 1) Capital Adequacy (CAR/CRAR > 9% for India vs 8% Global), 2) Leverage Ratio, 3) Liquidity Ratios (LCR & NSFR). Also, know the components: Tier-1 Capital (Core Equity) vs Tier-2 Capital (Subordinated Debt).
- [THE STRATEGIC METACOGNITION]: When studying any financial ratio, always map three things: The Formula (What is it?), The Purpose (Why do we need it?), and The Authority (Who sets the limit?). UPSC loves swapping the 'Authority' (e.g., claiming banks decide instead of RBI).
References define CAR/CRAR as capital held (shareholders' equity and defined capital) relative to risk-weighted assets and describe its role in protecting against loan losses.
High-yield for UPSC: CAR is central to banking regulation questions and links banking stability to macroprudential policy. Mastering this helps answer questions on bank safety, regulatory objectives, and impacts on credit growth; expect direct-definition, role-based and cause-effect (NPAs → capital erosion → lending constraints) question patterns.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-I Norms > p. 234
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2 Money and Banking- Part I > p. 95
Several references emphasize that CAR is measured against risk-weighted assets and that RBI prescribes risk weights for different loans.
Critical for solving numerical and conceptual questions on CRAR/CRAR computation and policy thresholds. Understanding RWA clarifies why different asset classes affect required capital differently and links to questions on bank risk management and depositor safety.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-I Norms > p. 234
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2 Money and Banking- Part I > p. 94
References reference Basel accords setting minimum CAR/CRAR levels and buffers (Basel I/III), situating CAR within global regulatory standards.
High relevance for UPSC essays and prelims/GS papers: connects international banking regulation to domestic RBI guidelines, buffer requirements, and implications for credit availability. Enables comparative and policy-impact questions (e.g., effects of higher minimum capital).
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-I Norms > p. 234
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-III Norms > p. 235
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.20 BASEL Norms > p. 93
Several references state Basel (I/II/III) prescribes minimum capital adequacy ratios (e.g., 8%, and higher under Basel III).
High-yield topic for banking and finance questions: understanding that Basel accords set international minimums explains regulatory uniformity across banks and frames policy debates on capital buffers. Connects to questions on financial stability, international banking regulation and India’s adoption of Basel norms.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-I Norms > p. 234
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.20 BASEL Norms > p. 93
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-III Norms > p. 235
Evidence shows the RBI issues guidelines (e.g., CRAR/CAR of 9% under Basel-I) and enforces minimums for scheduled banks.
Important for UPSC polity-economy linkage: shows how domestic regulators implement international norms and the legal/regulatory consequences for banks (limits on lending when below minimum). Useful for policy, regulation and banking governance questions.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-I Norms > p. 234
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2 Money and Banking- Part I > p. 95
References list specific Basel III requirements (Tier I ratio 4.5%, conservation buffer 2.5%, counter‑cyclical buffer 0–2.5%, total CRAR targets).
Concept clarifies how CAR is structured, not discretionary per bank: helps answer technical questions on capital composition and buffers, and links to macroprudential policy and bank risk-taking behaviour.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > Basel-III Norms > p. 235
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2 Money and Banking- Part I > p. 94
The 'Next Logical Question' is on D-SIBs (Domestic Systemically Important Banks). Since they are 'Too Big To Fail', RBI mandates them to maintain *higher* Common Equity Tier 1 (CET1) capital than other banks. Currently, SBI, HDFC, and ICICI are D-SIBs.
Apply the 'Fox Guarding the Henhouse' logic. If Statement 2 were true (banks decide their own CAR), profit-hungry banks would set it to 0% to maximize lending. Regulations exist precisely because individual agents cannot be trusted to self-regulate systemic risk. Thus, Statement 2 is logically impossible.
Mains GS-3 (Economic Growth vs Stability): High CAR requirements make banks safer (Stability) but lock up capital that could have been lent out, potentially slowing down credit growth. This links to the 'Twin Balance Sheet' problem and the need for Government Recapitalization of PSBs.