Banks are no strangers to risk, but crypto presents a different challenge entirely. With extreme volatility and unpredictable market swings, adding digital assets to a bank’s portfolio or using them for loans demands a rethink of one key safeguard: the capital adequacy ratio (CAR). 

In this guide, we explore how CAR works, why it matters more than ever when crypto is involved, and whether traditional banks can keep up with the risk models already used in DeFi.

What Is the Capital Adequacy Ratio and Why Should Crypto Change the Calculation?

The capital adequacy ratio (CAR) measures how much capital a bank holds relative to its risk-weighted assets. It’s like a financial cushion, there to absorb losses when things go wrong. 

The higher the CAR, the better equipped a bank is to survive unexpected shocks, including borrower defaults or asset value crashes.

Banks are typically required to maintain a minimum CAR under regulations such as Basel III. For example, a common minimum threshold is around 8%, meaning a bank must hold capital equivalent to at least 8% of its risk-weighted credit exposures. This helps prevent insolvency and protects customer deposits if loans go bad.

Now, imagine what happens when you introduce crypto into the picture. Bitcoin might surge 30% in a week, but it could just as easily drop 40% the next. 

If a bank starts holding volatile tokens as assets, or worse, issuing loans backed by crypto collateral, the potential for sudden loss is far greater than with traditional assets like government bonds or mortgages.

In this context, the standard CAR might not be enough. Treating crypto like other risk-weighted assets would underestimate its volatility and expose banks to greater losses than they’re prepared for. 

Some analysts argue that crypto assets should carry a risk weight of 1,250% under current frameworks, which would require significantly more capital to be held against them. This makes it clear, which is that if banks are to enter crypto, their capital buffer might need to grow dramatically.

Read more: US Regulators Push for Crypto Adoption in Banking

Could Banks Learn from DeFi? Comparing Risk Models and Capital Expectations

While banks have regulators, stress tests, and capital rules, decentralised finance (DeFi) operates very differently. 

Protocols like Aave and Compound often require borrowers to overcollateralise loans by at least 150%, meaning they must deposit $1.50 in crypto to borrow $1.00. This might seem excessive, but it accounts for the same thing CAR is meant to address, which is volatility.

DeFi apps also use real-time liquidation mechanisms. If collateral drops in value too quickly, the position is liquidated automatically, avoiding long delays or credit losses. 

It’s not perfect, and liquidations can fail during major crashes, but the model is designed with crypto’s unique volatility in mind.

Now compare this to traditional banks, where loans are often backed by static collateral and repayments are assessed manually or through delayed systems. If banks begin to adopt crypto, they’ll need to adapt both their risk models and technology. 

Holding just 8% capital against a volatile crypto portfolio might not cut it. A more reasonable CAR might be closer to 20% or higher if the assets include cryptocurrencies.

This raises a major issue: can banks realistically compete in crypto lending without becoming too exposed? 

Or will they need to build entirely separate risk frameworks for these assets, perhaps even ringfencing them from traditional operations? Some institutions may choose to adopt hybrid models, using lessons from DeFi to inform their safeguards.

The bottom line is this: DeFi already assumes crypto is unstable and designs protections accordingly. Banks, if they wish to participate, must raise their standards rather than apply outdated models to a new and unpredictable asset class.

Read more: The Banking Sector Adopts More Stablecoins

What Should the CAR Look Like for Banks Handling Crypto Exposure?

The ideal capital adequacy ratio for banks holding or lending against crypto isn’t set in stone, but it must be significantly higher than the minimums used for traditional finance. 

Given how quickly the value of crypto assets can swing, the capital cushion should reflect worst-case scenarios.

Let’s take an example. If a bank holds $100 million in crypto-backed loans, and those loans are backed by assets with a 60% drop risk in extreme conditions, holding only $8 million in capital (the standard 8% CAR) would be insufficient. 

That loss could wipe out the capital entirely and leave depositors at risk. A more suitable CAR in this scenario might be 25% to 30%, giving the bank enough flexibility to absorb sharp corrections without triggering a solvency crisis.

Some might argue this is too conservative, but history supports caution. We’ve seen major coins lose half their value in days, Terra, Celsius, and even Ethereum have all faced moments of sharp drawdown. For banks, which are built on stability and trust, that kind of volatility is a serious liability.

To mitigate this, banks could explore crypto products with lower volatility, such as stablecoins. But even these have their risks, particularly algorithmic ones that are not backed by reserves. 

Alternatively, banks might limit their exposure to a small portion of their overall assets, effectively creating a ‘crypto sandbox’ within the larger institution.

Ultimately, the capital adequacy ratio should be tailored to the risk profile of the assets involved. Applying the same rules used for commercial loans or real estate simply does not work when dealing with digital assets that can lose 20% of their value in an afternoon.

Conclusion

The capital adequacy ratio has always been a fundamental part of bank safety. But as institutions begin to explore crypto, relying on outdated thresholds could leave them exposed. 

With volatility baked into crypto markets, banks must reassess how much capital they need to protect themselves and their customers.

If traditional finance wants to tap into digital assets, it must do so with proper safeguards. Crypto may be exciting, but it’s also unforgiving. 

Platforms like Bitrue offer a safer and easier way to start your crypto journey, especially for those looking to explore digital assets without the baggage of legacy systems.

Frequently Asked Questions

1. Why is the capital adequacy ratio important for banks entering crypto?
CAR helps ensure banks hold enough capital to cover potential losses. With crypto’s volatility, banks must hold even more capital to stay solvent during price crashes.

2. How does crypto risk compare to traditional loans or assets?
Crypto is far more volatile. A traditional asset like a mortgage might lose 5% in a downturn, but crypto can drop 30% in a single day, demanding stronger capital buffers.

3. Can banks use DeFi-style models to manage crypto lending?
Possibly. DeFi’s overcollateralisation and liquidation mechanisms are designed for volatility. Banks could adopt similar safeguards or raise their CAR significantly when handling crypto.

Investor Caution 

While the crypto hype has been exciting, remember that the crypto space can be volatile. Always conduct your research, assess your risk tolerance, and consider the long-term potential of any investment.

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