Introduction

What Is Bank Capital? When a bank's assets are subtracted from its liabilities, the resulting amount is the bank's capital, also known as its net worth or equity value to its investors. Cash, government bonds, and interest-bearing loans make up the asset portion of a bank's capital (e.g., mortgages, letters of credit, and inter-bank loans). Loan-loss reserves and other debts are included in the liabilities portion of a bank's capital. You can think of a bank's capital as the point at which its debts would still be covered if it were to liquidate its assets.

A bank's capital consists of the funds it has raised from shareholders and other investors and any retained earnings. A bank can increase its capital by, for instance, issuing more shares or keeping profits in-house rather than dispersing them to shareholders through dividends. Capital and debt are the two main types of funding for financial institutions. Debt is the amount of money owed to creditors. Customer deposits, debt securities issued, and bank loans are all examples of debt. The bank uses the money from those two sources in various ways, such as making loans to customers and investing the money elsewhere. A bank's assets include its loan portfolio, investments, and available cash.

How Does Bank Capital Operate?

Bank capital refers to the value of a bank's equity instruments, which are used to absorb losses and are repaid last in the event of bank liquidation. National regulators define regulatory capital, which is generally understood as the difference between a bank's assets and liabilities. The majority of the banking regulatory system is based on international agreements such as Basel I, Basel II, and Basel III, which outline international standards adopted by the Basel Committee on Banking Supervision. These standards define the regulatory bank capital that is strictly monitored by market and banking regulators.

Financial institutions, including the concept of bank capital, are subject to stringent regulation because they play a vital role in the economy. Banks collect deposits and put them to productive use through loans. Basel III, the latest international banking regulation agreement, provides a framework for determining regulatory bank capital, but individual countries may have different requirements.

How Does Capital Maintain Bank Security?

Capital acts as a safety net to prevent financial collapse. If a significant number of borrowers unexpectedly cannot repay their debts, or if the value of some of the bank's investments suddenly drops, the bank will incur a loss and, without sufficient capital reserves, may even go bankrupt. Should this occur, the company will be able to continue operating and meeting the needs of its customers despite the setback, thanks to the solid foundation on which it is built.

How Much Capital Must Banks Possess?

First, all banks under European banking supervision must comply with the European regulation that sets the minimum overall capital requirement (also known as the "Pillar 1 requirement") at 8% of banks' risk-weighted assets. But how exactly do risk-adjusted asset values function? A bank's capital requirements are the product of its asset value and riskiness (risk weights). Indicators of risk show how dangerous an investment strategy is thought to be. Since the amount of capital needed to cover less risky assets is less, banks can hold onto more of their funds. Mortgage loans, backed by real estate (home or apartment), carry much less peril than unsecured loans. This means that mortgage loans require less capital for the bank to back them up than unsecured loans.

Second, regulators have instituted a higher minimum capital requirement (Pillar 2). Here's where Europe's financial rules come into play. The European Central Bank and the regulatory bodies of the participating countries conduct thorough examinations of each bank and assess the risks to which each is exposed. This is done through an annual Supervisory Review and Evaluation Process (SREP). If regulators determine that the minimum capital requirements are insufficient to cover the institution's risks, banks are required to hold more capital. There will be legal repercussions for failing to meet the minimum and additional capital requirements. The extent of these consequences depends on the nature of the breach. For instance, the regulator may insist that the bank develop a strategy for resuming full compliance with capital requirements.

Conclusion

There are various ways to define capital (or its net worth). The first step in understanding a bank's capital is to realize the difference between the bank's fixed liabilities and assets. Second is the amount owed to bank shareholders if all bank assets were liquidated at their book value. Third, it serves as a safety net in case the bank's liabilities exceed its assets.