What Is Bank Capital?
Let me explain bank capital directly: it's a bank's net worth or equity value, which you get by subtracting its liabilities from its assets.
When you look at the asset side, it includes things like cash, government securities, and interest-earning loans such as mortgages. On the liabilities side, you'll find loan-loss reserves and any debt the bank owes.
Think of bank capital as the equity value – that's the amount that would go to creditors and investors if the bank went bankrupt and had to liquidate everything.
Key Takeaways
- Bank capital is the money a bank has available to handle unexpected losses or financial crises.
- National governments and international standards regulate bank capital levels.
- It matters to investors and creditors as a sign of the bank's financial strength.
How Bank Capital Works
Bank capital is the value of a bank's equity instruments that can absorb losses, and they have the lowest priority in payments during liquidation. You can define it simply as assets minus liabilities, but national authorities have their own definitions for regulatory capital.
The main regulatory framework comes from the Basel Committee on Banking Supervision, through accords like Basel I, Basel II, and Basel III. These provide the standards for regulatory bank capital that regulators watch closely.
Banks play a key role in the economy by taking savings and turning them into loans for productive uses, so the industry and bank capital definitions are tightly regulated. Each country might have its own rules, but Basel III offers the latest international framework for defining regulatory capital.
Regulatory Capital Classifications
Under Basel III, regulatory bank capital splits into tiers based on subordination and how well it absorbs losses, with a clear difference between instruments when the bank is solvent versus bankrupt. Common equity tier 1 (CET1) covers the book value of common shares, paid-in capital, and retained earnings, minus goodwill and other intangibles. CET1 instruments need the highest subordination and no maturity date.
Tier 1 Capital
Tier 1 capital includes CET1 plus other instruments subordinated to subordinated debt, with no fixed maturity, no redemption incentives, and the option for the bank to cancel dividends or coupons anytime. It consists of shareholders' equity and retained earnings, and it's used to gauge a bank's financial health when absorbing losses without stopping operations.
From a regulator's perspective, bank capital – especially Tier 1 – is the core measure of a bank's financial strength. It's the primary funding source, holding most of the bank's accumulated funds generated to support it during losses so business doesn't shut down.
Basel III sets the minimum tier 1 capital ratio at 8.5%, calculated by dividing tier 1 capital by total risk-weighted assets. For instance, if a bank has $176.263 billion in tier 1 capital and $1.243 trillion in risk-weighted assets, the ratio is 14.18%, which exceeds the 8.5% minimum and the 10.5% total capital ratio.
Tier 2 Capital
Tier 2 capital includes unsecured subordinated debt and stock surplus with original maturity under five years, minus investments in non-consolidated financial subsidiaries in some cases. Total regulatory capital is Tier 1 plus Tier 2.
It also covers revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves. Tier 2 is supplementary because it's less reliable than Tier 1 – harder to calculate accurately and made up of assets tougher to liquidate.
Under Basel III, the minimum total capital ratio is 10.5%, but there's no specific requirement just for Tier 2.
Book Value of Shareholders' Equity
You can think of bank capital as the book value of shareholders' equity on the balance sheet. Since banks revalue financial assets more often than other industries that keep fixed assets at historical cost, this equity serves as a good proxy for bank capital.
Typical items in shareholders' equity include preferred equity, common stock, paid-in capital, retained earnings, and accumulated comprehensive income. You calculate it as the difference between assets and liabilities.
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