Bank capital is the ownership interest in a bank. Equity capital represents a bank’s net worth, the difference between its assets and liabilities. It’s the value of assets financed by the bank’s owners, rather than depositors or other sources of funds. The depositor’s funds are liabilities of the bank, not assets, and are subject to reserve requirements. Capital serves as a cushion to absorb any loan and investment losses and serve as a support in the prevention of a banks failure. Banks seek to hold enough capital to cushion any potential losses to lenders and depositors and maintain enough capital to provide financial flexibility for future demands. Bank capital is a key component in the banking industry’s ability to lend. Bank capital can also create a compelling reason to manage a bank in a prudent manner, because the bank owners’ equity is at risk in the event of a failure. The amount of bank capital is always a significant concern for regulators in the banking industry.
A bank can fund its business in two basic fashions, either with borrowed money or with funds provided by its owners or investors. Borrowing funds includes deposits from consumers and businesses and generates contractual liabilities for the bank. If a bank is unable to pay any of these liabilities when they are due, the bank can fail. In comparison, the owner’s capital or investments can gain or lose value without causing the bank to default on its obligations. Ignoring other facets of banking, the greater the proportion of a bank’s operations that are financed with capital funds contributed by its owners, the more likely the bank will be able to continue to pay its obligations during periods of economic adversity.
Under risk based capital guidelines that are adopted by the Federal Reserve, bank assets are classified by risk because they represent loans and investment of funds, and capital requirements that are determined from the risks assigned to each asset category. Under these generally accepted bank conventions, bank capital is defined in tiers or categories that include shareholders’ equity, retained earnings, reserves, blended capital instruments, and subordinated term debt. Capital ratios are commonly measured as a percent of bank assets or risk-weighted bank assets.
Bank capital serves as an important cushion against unexpected losses. It creates a strong incentive to manage a bank in a prudent manner, because the bank owners’ equity is at risk in the event of a failure.1 Thus, bank capital plays a critical role in the safety and soundness of individual banks and the banking system.
Bank capital is often defined in tiers or categories that include shareholders’ equity, retained earnings, reserves, hybrid capital instruments, and subordinated term debt. Capital ratios are commonly measured as a percent of bank assets or risk-weighted bank assets.
Credit risk is the number one risk problem that most banks face. Credit risk is an inherent part of business in most financial institutions and is more problematic for banks as credit risk tends to fluctuate with the business cycles. Credit risk can cause the loan portfolio of a bank to dramatically drop in value as loan delinquencies rise. As economic conditions change and the assets and liabilities of a bank shift, banks can adjust their capital positions in several ways. Banks can raise more capital, which can be costly in terms of reducing dividends or issuing stock or qualified debt. Another option would be to rebalance their portfolios. Since capital requirements are based on the distribution of assets, banks could reduce the amount of capital they are required to hold by moving toward less risky holdings. The unfortunate result of banks repositioning their assets to move towards a better capital arrangement is it leads to banks scaling back their overall lending. The reduction lending leads to drop an economic activity and contracting economy.
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