It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
The risk weighted assets take into account credit risk, market risk and operational risk.
The Basel III norms stipulated a capital to risk weighted assets of 8%.
Understanding CAR.
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets.
Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% (which includes a 2.5% conservation buffer) under Basel III.
The capital adequacy regulation is an international standard to safeguard the banks through setting a risk-sensitive minimum capital requirement.
The regulatory authority sets the regulatory capital, and the operating banks are required to maintain the adequate level of capital.