Bank capital – definition and meaning
Bank capital is a storage of cash and safe assets that banks hold as a buffer. Bank capital is like the airbags in vehicles. It is there to protect banks’ creditors in case they have to liquidate their assets. In most countries, regulators make banks have a minimum capital adequacy ratio.
From an accountant’s viewpoint, bank capital is the bank’s total assets minus liabilities. In other words, the difference between the value of what it has and what it owes.
A bank’s assets include cash, interest-earning loans like inter-bank loans, letters of credit, and mortgages. Bank assets also include government securities.
A bank’s liabilities comprise any debt it owes plus loan-loss reserves.
Since the 2007/8 global financial crisis, banks, the media, and regulators have been talking a lot about bank capital.
According to the Federal Reserve Bank of San Francisco:
“[Bank capital] creates a strong incentive to manage a bank in a prudent manner, because the bank owners’ equity is at risk in the event of a failure. Thus, bank capital plays a critical role in the safety and soundness of individual banks and the banking system.”
Difference between bank capital and bank liquidity
Although there is a close relationship between a bank’s capital and liquidity, they are quite different.
Liquidity is a measure of how easily one can convert assets into cash. We can convert liquid assets into cash immediately if we have to meet financial obligations.
Examples of liquid assets include cash, government debt, and central bank reserves. For a financial institution to remain viable, it must have enough liquid assets to meet short-term obligations. The term ‘viable,’ in this context, means capable of making a profit year after year.
For example, it must have enough liquidity to deal with withdrawals by account holders.
Capital acts as a financial buffer which can absorb unexpected losses. It is the difference between a bank’s assets and liabilities.
For a bank to remain solvent, its assets must be greater than its liabilities.
More banks fail or need government help during a financial crisis because they don’t have enough capital or liquidity. Sometimes banks have a combination of both problems.
US Federal Reserve requirements today
The US Federal Reserve Bank has worked to increase the levels of both capital and liquidity in financial organizations. The Federal Reserve Bank (Fed) is the central bank of the United States.
The Basel III Liquidity Coverage Ratio came into force in September 2014. Regulators across the world got together and formulated the Basel III Liquidity Coverage Ratio. It requires large institutions to hold levels of liquid assets “sufficient to protect against constraints on their funding during times of financial turmoil.”
Regulators across the world also implemented The Basel III Capital Standards. Large firms must hold enough capital to absorb losses in severely adverse environments. During crises, they must also continue lending to businesses and households.
The Fed said that from 2008 to 2012, the country’s largest banks doubled the amount of high-quality capital they held.
The Bank of England says the following about bank capital in a document titled ‘Bank capital and liquidity’:
“Capital can be considered as a bank’s ‘own funds’, rather than borrowed money such as deposits.”
The term ‘own funds’ refers to such items as retained earnings and share capital. In other words, money that the bank has borrowed and has to repay is not ‘own funds’.
“Taken together, these own funds are equivalent to the difference between the value of total assets and liabilities,” the BoE added.
Video – ECB’s view on bank capital
In this video, Danièle Nouy, the ECB’s supervision head, explains that in Europe there are too many different interpretations of what bank capital means.The European Parliament might have to pass new legislation which precisely defines what bank capital means, she added.