Bank capital is a storage of cash and safe assets that banks hold as a buffer, like the airbags in vehicles, to protect their creditors in case their assets are liquidated. In most countries, banks are legally required to have a minimum capital adequacy ratio.
As far as accountants are concerned, bank capital is the difference between the value of what a bank has and what it owes, i.e. total assets minus liabilities.
A bank’s assets include cash, interest-earning loans like inter-bank loans, letters of credit and mortgages, and government securities.
Its liabilities consist of any debt it owes plus loan-loss reserves.
Bank capital acts as a cushion (force field) so that the financial institution can absorb the shocks from financial crises.
Bank capital has been much talked about by banks themselves, the media and regulators since the 2007/8 global financial crisis struck.
“It (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.1 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 a bank’s capital and liquidity are closely related, they are quite different.
Liquidity – this is a measure of how easily assets can be converted into cash. Liquid assets can be turned into cash immediately if required 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, such as 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. In order to remain solvent, a bank’s assets must exceed its liabilities.
During economic crises, a higher number of banks fail or need government help because they have inadequate capital, not enough liquidity, or a combination of both.
US Federal Reserve requirements today
The United States’ central bank, The Federal Reserve, has worked to increase the levels of both capital and liquidity in financial organizations.
The Basel III Liquidity Coverage Ratio was implemented in September 2014. It was formulated together with global regulators and requires large institutions to hold levels of liquid assets “sufficient to protect against constraints on their funding during times of financial turmoil.”
The Basel III capital standards, which were also formulated with US and global regulators, were implemented. Large firms are required to hold enough capital to absorb losses in severely adverse environments, and continue to lend to businesses and households.
According to the Federal Reserve, from 2008 to 2012 the amount of high-quality capital held by the largest American banks has more than doubled.
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. A bank’s own funds are items such as its ordinary share capital and retained earnings — in other words, not money lent to the bank that has to be repaid. Taken together, these own funds are equivalent to the difference between the value of total assets and liabilities.”
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. She says it may be necessary to get legislation passed in the European Parliament to define exactly what capital is.