Introduce

What is bank capital? When a bank's assets are subtracted from its liabilities, the resulting amount is its capital, also known as its investors' net worth or equity value. Cash, government bonds, and interest-bearing loans comprise the asset component of a bank's capital (such as mortgages, letters of credit, and interbank loans). Provisions for loan losses and other liabilities are included in the liabilities portion of the bank's capital. You can think of a bank's capital as the point at which it would still be able to service its liabilities if its assets were to be liquidated.

A bank's capital includes the money it has raised from shareholders and other investors and any retained earnings. Banks can increase capital by issuing more shares or keeping profits in-house rather than distributing them to shareholders through dividends. Capital and debt are the two main financing methods of financial institutions. Debt is the amount of money owed to the creditor. Customer deposits, debt securities issued, and bank loans are examples of debt. Banks use funds from these two sources in various ways, such as making loans to customers and investing the funds elsewhere. A bank's assets include its loan portfolio, investments, and available cash.

How does bank capital work?

Bank capital refers to the value of equity instruments that a bank uses to absorb losses and is eventually repaid when the bank is liquidated. National regulators define regulatory capital as the difference between a bank's assets and liabilities. Most systems of banking supervision are based on international agreements, such as Basel I, Basel II, and Basel III, which outline the international standards adopted by the Basel Committee on Banking Supervision. These standards define regulatory bank capital that is strictly monitored by market and banking regulators.

Financial institutions, including the concept of bank capital, are highly regulated due to their vital role in the economy. Banks collect deposits and use them for productive purposes through loans. Basel III, the latest international agreement on banking regulation, provides a framework for determining regulatory bank capital, but countries may have different requirements.

How does capital maintain bank safety?

Capital acts as a safety net against financial collapse. If many borrowers unexpectedly cannot repay their debts, or if some of the bank's investments suddenly lose value, the bank will suffer losses, have insufficient capital reserves, and may even fail. If this happens, the company will be able to continue to operate despite setbacks and meet the needs of its customers, thanks to the solid foundation it has built.

How much capital must a bank have?

First, all banks subject to European banking supervision must comply with European regulations, which set a minimum overall capital requirement (also known as the "first pillar requirement") at 8% of the bank's risk-weighted assets. But how exactly does risk-adjusted asset value work? A bank's capital requirements are a product of its asset values and risks (risk weights). Risk indicators show how risky an investment strategy is considered to be. With less capital required to cover low-risk assets, banks can hold more funds. A mortgage-backed by real estate (a house or condo) carries far less risk than an unsecured loan. This means that secured loans require less bank capital than unsecured loans.

Second, regulators set higher minimum capital requirements (Pillar 2). This is where European financial rules come into play. The European Central Bank and the supervisory authorities of the participating countries conduct a thorough inspection of each bank and assess the risks each bank faces. This is done through the annual Surveillance Review and Evaluation Process (SREP). Banks must hold more capital if regulators determine that minimum capital requirements are insufficient to cover an institution's risk. Failure to meet the minimum and additional capital requirements will have legal consequences. The extent of these consequences depends on the nature of the violation. For example, regulators may insist that banks develop strategies to return to full compliance with capital requirements.

In conclusion

There are various ways of defining capital (or its equity). The first step in understanding bank capital is understanding the difference between a bank's fixed liabilities and assets. The second is the amount owed to bank shareholders if all bank assets were liquidated at book value. Third, it acts as a safety net if a bank's liabilities exceed its assets.