Bank Capital Meaning
Bank Capital, also known as the bank’s net worth, is the difference between a bank’s assets and liabilities. It primarily acts as a reserve against unexpected losses and protects the creditors in case of bank liquidation. 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.
Regulatory authorities look at bank capital ratio, especially the tier 1 metric as a symbol of the core strength of the bank in terms of its finance based on international standards set and regulated by the Basel Committee on Banking Supervision. This also gives creditors an idea of the bank’s assets if the bank were to be liquidated today.
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Bank Capital Explained
Bank Capital plays a key role in banking operations. The risk element is always present in banking operations; at any time, losses can happen. To protect the banks from insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow. and public deposits, the banks maintain capital to protect themselves against 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.
Maintaining an adequate level of capital is vital for banks. It not only safeguards the interests of depositors but also ensures the bank’s ability to continue lending and conducting its operations even in adverse economic conditions. Regulators set minimum capital requirements that banks must meet to operate safely and mitigate systemic risks.
Bank capital management gives them a buffer against loan defaults, economic downturns, and unexpected losses, allowing banks to absorb these shocks without resorting to government bailouts or risking insolvency. It also serves as a measure of a bank’s financial health, as a bank with higher capital ratios is generally considered more resilient and less risky to its stakeholders.
Bank capital ratio requirements are regulations imposed by financial authorities to ensure banks maintain a minimum level of capital relative to their risk-weighted assets. These requirements aim to enhance financial stability and protect depositors and the broader economy. Let us understand them through the points below.
- The requirements mandate banks to maintain a minimum Common Equity Tier 1 (CET1) capital ratio of 4.5% of risk-weighted assets
- A total capital ratio of 8%.
- Countercyclical buffers, capital conservation buffers, and systemic risk buffers.
- These rules vary by jurisdiction and are enforced by banking authorities to mitigate risks and prevent bank failures.
The Fund structure states how the bank will finance its operations using the available funds. It can be equity, debt, or hybrid securitiesHybrid SecuritiesHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering..
Types of Bank Capital
Banks must maintain a certain amount of liquid assets in correspondence to its risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement.. 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 goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price., if any. It indicates the financial health of the bank. Also, 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% 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.
Bank X has $100 billion in Tier 1 capital. Its risk-weighted assets are $1000 Billion. (i.e) the Tier 1 capital ratioThe Tier 1 Capital RatioTier 1 Capital Ratio is the ratio of Tier 1 capital (capital that is available for banks on a going concern basis) as a proportion of the bank’s risk-weighted assets. Tier 1 capital includes the bank’s shareholder’s equity, retained earnings, accumulated other comprehensive income, and contingently convertible and perpetual debt instruments of the bank. is 10 %, which is more than the Basel IIIBasel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision. requirement, which is 7%.
#2 – Tier 2 Capital
It consists of funds not disclosed in the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. of the bank. It includes revaluation reserveRevaluation ReserveA revaluation reserve is a non-cash reserve created to reflect the asset's true value when the market value of a certain asset category is more or less than the asset's value at which it is recorded in the books of account., hybrid capital instruments, subordinated term debt, general provisions, loan loss reserves, undisclosed reserves, fewer investments in unconsolidated subsidiaries, and other financial institutions.
Tier 2 capitalTier 2 CapitalTier 2 capital, also known as supplementary capital, is the second layer of bank capital requirements. It consists of hybrid instruments, general provisions and revaluation reserves. Uneasy to liquidate; Tier 2 capital is considered less secure. is additional capital as it is less trustworthy than Tier 1. It is difficult to measure this capital as the assets in this bank capital ratio is not easy to liquidate. Banks will divide these assets into the upper and lower levels based on the individual assets’ liquidity.
Under Basel III, they must maintain a minimum of 8% of the total capital ratio.
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 subordinated issues, undisclosed reserves, and loan loss reserves compared to tier 2 capital.
Tier 1 Capital must be more than the joined Tier 2 and Tier 3 Capital.
Bank capital management is crucial for maintaining the stability of financial institutions and the broader economy. Several key ratios are used to ensure banks comply with these requirements:
- Common Equity Tier 1 (CET1) Capital Ratio: This ratio measures the core equity capital (common stock and retained earnings) as a percentage of risk-weighted assets. Regulators typically require a minimum CET1 ratio to ensure a strong capital foundation.
- Tier 1 Capital Ratio: Tier 1 capital includes CET1 capital and additional Tier 1 capital, such as certain hybrid instruments. It is expressed as a percentage of risk-weighted assets, providing a broader measure of a bank’s core capital strength.
- Total Capital Ratio: This ratio combines Tier 1 capital with Tier 2 capital, including subordinated debt and other qualifying instruments. It is expressed as a percentage of risk-weighted assets and ensures banks have a sufficient capital buffer.
- Leverage Ratio: The leverage ratio assesses capital adequacy without considering risk-weighted assets. It compares Tier 1 capital to average total consolidated assets, providing a simple measure of how well capital supports the bank’s total assets.
- Countercyclical Buffer: This buffer requires banks to set aside additional capital during periods of economic growth to be used during downturns. It is calculated as a percentage of risk-weighted assets and aims to mitigate pro-cyclical lending behavior.
- Capital Conservation Buffer: This buffer ensures banks maintain a minimum capital buffer above regulatory minimums to withstand economic stress. It is expressed as a percentage of CET1 capital.
- Systemic Risk Buffer: Some banks may be required to hold an additional buffer to mitigate risks associated with their systemic importance. This buffer varies by jurisdiction and depends on a bank’s systemic significance.
How Does It Increase or Decrease?
Banks raise financing from various sources to provide loans to the customers on which they charge interest, which is more than the cost they borrow. The difference is profit.
- Raising funds from shareholders – Banks, through public issues, raise capital, which is used for banking operations. The return to the shareholders will be in the form of dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. and appreciation of the share value.
- Obtaining loans from financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. ;
- Government funding the bank
- Term deposits, savings account;
Let us understand the functions of bank capital management through the discussion below.
- 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 assures the depositors and the creditors that their funds are safe and indicates the bank’s ability to pay for its liabilities.
- It funds for expansion in banking operations or for procuring 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 assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet. can be converted into cash easily. (Eg) Central bank reserves, Government bonds, etc. To manage the business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation., 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 for a bank to absorb losses. The bank’s assets should be greater than the liabilities to stay solvent. Minimum levels of required bank capital need to be maintained per the Basel requirement to manage the bank’s functioning.
This has been a guide to what is Bank Capital and its meaning. Here we discuss its types, examples, requirements, functions, and structures. You can learn more about financing from the following articles –