Bank Capital: How Money and Banking REALLY works

A bank's capital, also known as equity, is the margin by which creditors are covered if the bank's assets were liquidated.  A measure of a bank's financial health is its capital/asset ratio, which is required to be above a prescribed minimum.

Assets and Liabilities

When a bank creates a deposit to fund a loan, its assets and liabilities increase equally, with no increase in equity.  That causes its capital ratio to drop.  Thus the capital requirement limits the total amount of credit that a bank may issue.

It is important to note that the capital requirement applies to assets while the reserve requirement applies to liabilities.  The reserve requirement imposes a lower limit on the amount of reserves a bank must own relative to the demand deposits of its customers.

Capital Requirements

In 1989 the U.S. adopted the capital requirements established by the Bank for International Settlements (BIS) in Basel, Switzerland.  The minimum capital is specified as a percentage of the risk-weighted assets of the bank.  The following table shows the weight assigned to each type of asset.
 

The BIS rules set requirements on two categories of capital, Tier 1 capital and Total capital:

Tier 1 capital is the book value of its stock plus retained earnings.  Tier 2 capital is loan-loss reserves plus subordinated debt.**  Total capital is the sum of Tier 1 and Tier 2 capital.

Tier 1 capital must be at least 4% of total risk-weighted assets.  Total capital must be at least 8% of total risk-weighted assets.

**Subordinated debt is long term debt that, in case of insolvency, is paid off only after depositors and other creditors have been paid.  Thus it can be used like equity to provide those creditors some protection against insolvency.

An Example

Assume a bank has the following assets:
 

The total risk-weighted assets is 0 x $40m + 0 x $80m + 0.2 x $100m + 0.5 x $200m + 1.0 x $300m + 1.0 x $80m = $500m. 

The bank must have Tier 1 capital of at least .04 x $500m = $20m and Total capital of at least .08 x $500m = $40m.

Leverage Requirement

In addition to the BIS capital requirement, the U.S. imposes a separate leverage requirement on banks.  This is based on the unweighted sum of all balance sheet assets.  Off-balance sheet assets such as standby letters of credit are not counted.  The minimum allowable ratio of Tier 1 capital to total assets is 3%.  Bank regulators can increase that to as much as 6% depending on the quality of a bank's assets.  No leverage requirement is specified for total capital.

In the example above, balance sheet assets total $720m.  Assuming the bank must meet a 4% leverage requirement, it must hold Tier 1 assets of at least .04 x $720m = $28.8m.  Since that exceeds the $20m BIS Tier 1 capital requirement, the leverage requirement governs. 

Meeting the New Standards

If a bank is having difficulty meeting the BIS capital ratio requirements, there are a number of ways for it to increase the ratio.  If it is publicly traded, it can issue new stock or sell more subordinated debt.  However that may be costly if the bank is in a weak position.  Small banks generally do not have the option of selling new stock since most are not publicly traded. 

If the bank cannot increase its equity, it can reduce its assets to improve the capital ratio.  However shrinking the balance sheet is not attractive because it hurts profitability.  Another option is to seek a merger with a stronger bank.

Updating the Requirements

Since the BIS capital adequacy requirements were defined and adopted in 1989, banking has become far more complex.  The BIS has been working to better assess the risks in the various assets that banks hold.  While the basic methodology of limiting a bank's risk-weighted assets relative to its capital will be retained, more categories and revised weightings are now proposed.  How soon these revisions will be universally accepted however is difficult to predict.