Bank Capital Definition
Bank Capital, also known as net worth of the bank is the difference between a bank’s assets and its liabilities and primarily acts as a reserve against unexpected losses and in addition, protects the creditors in case of liquidation of the bank. The bank’s assets are cash, government securities, and loans offered by banks that earn interest (Eg. Mortgage, letter of credit). The bank’s liabilities are any loans/ debt obtained by the bank.
Types of Bank Capital
Banks have to maintain a certain amount of liquid assets in correspondence to its risk-weighted assets. The Basel accords are banking regulations that ensure that the bank has enough capital to handle the operations and obligations.
There are three types:
#1 – Tier 1 Capital
It consists of the bank’s core capital (i.e.) Shareholders’ equity and the disclosed reserves (retained earnings) less goodwill, if any. It indicates the financial health of the bank. It consists of all reserves and funds of the bank. It acts as primary support in the case of the absorption of losses. It appears in the bank’s financial statement.
Under Basel III, they need to maintain a minimum of 7% of Risk-weighted assets in Tier 1 capital. Plus, banks also have to hold an additional buffer of 2.5% of risky assets. Risk-weighted assets indicate the bank’s exposure to credit risk from the loans provided by the bank.
Example:
Bank X has $100 billion in Tier 1 capital. Its risk-weighted assets are $1000 Billion. (i.e) the Tier 1 capital ratio is 10 %, which is more than the Basel III requirement, which is 7%.
#2 – Tier 2 Capital
It consists of funds that are not disclosed in the financial statements of the bank. It includes revaluation reserve, hybrid capital instruments, subordinated term debt, general provisions, loan loss reserves, and undisclosed reserves, fewer investments in unconsolidated subsidiaries, and in other financial institutions.
Tier 2 capital is additional capital as it is less trustworthy than the Tier 1 capital. It is difficult to measure this capital as the assets in this capital are not easy to liquidate. Banks will divide these assets into the upper level and lower level based on the liquidity of the individual assets.
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Under Basel III, they need to maintain a minimum of 8% of the total capital ratio.
Example:
Bank X has $15 Billion of Tier 2 Capital. The Tier 2 capital ratio is 1.5%, which is more than the Basel III requirement.
The Total capital ratio is 11.5% (i.e) Tier 1 + Tier 2 = 10% +1.5% =11.5%. Which is more than the Basel III requirement of 10.5%? (along with the additional buffer)
#3 – Tier 3 Capital
Tier 3 Capital is tertiary capital. It is there to shield the market risk, commodity risk, and foreign currency risk. It includes more of subordinated issues, undisclosed reserves and loan loss reserve in comparison to tier 2 capital.
Tier 1 Capital must be more than the joined Tier 2 and Tier 3 Capital.
How Bank Capital Increase or Decrease?
Bank raises financing from various sources to provide loans to the customers on which they charge interest, which is more than the cost at which they borrow. The difference is profit.
- Raising funds from shareholders – Banks through public issues raise capital, and the same is used for banking operations. The return to the shareholders will be in the form of dividends and appreciation of the share value.
- Obtaining loans from financial institutions;
- Government funding the bank
- Term deposits, savings account;
Functions
- Bank capital acts as a protection to the bank from unexpected risks and losses.
- It is the net worth available to the equity holders.
- It gives assurance to the depositors and the creditors that their funds are safe, and it indicates the ability of the bank to pay for its liabilities.
- It funds for expansion in banking operations or for the procurement of any assets.
Difference Between Bank Capital and Bank Liquidity
Bank Liquidity acts as a measure of the bank’s assets, which is readily available to settle the dues and to manage the working capital components and business operations. Liquid assets can be converted into cash easily. (Eg) Central bank reserves, Government bonds, etc. To manage the business operations, banks should have sufficient liquid assets (Eg) Cash withdrawals by bank account holders, Repayment of term deposits on maturity, and other financial obligations.
It is the net worth of the bank, which is the difference between the bank’s assets and liabilities. It acts as a reserve to a bank to absorb losses. Bank’s assets should be greater than the liabilities to stay solvent. Minimum levels of required bank capital need to be maintained as per the Basel requirement to manage the functioning of the bank.
Structure
The Fund structure states how the bank will finance its operations by using the available funds. It can be equity, debt, or hybrid securities.
Conclusion
Bank Capital plays a key role in banking operations. The risk element is always present in banking operations, and anytime losses can happen. To protect the banks from insolvency and to protect the public deposits, the banks maintain capital to protect itself against the uncertainties and losses.
The amount of capital a bank needs depends upon its operations and its associated risks, more the risk more the capital. It is also used for the expansion of banks and other operational purposes. Without proper capital, the bank may even go bankrupt. Therefore, it needs to be maintained at proper levels, and it should fall below the limits set by law.
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