23 May 2019
Capital is a key ingredient for safe and sound banks and here is why. Banks take on risks and may suffer losses if the risks materialise. To stay safe and protect people’s deposits, banks have to be able to absorb such losses and keep going in good times and bad. That’s what bank capital is used for.
But how much capital should a bank hold? The answer lies in the risks it takes. The bigger the risks, the more capital it needs. That’s why it’s essential that banks continuously assess the risks they are exposed to and the losses they may incur. Their assessments are checked and challenged by banking supervisors. Supervisors are responsible for monitoring banks’ financial health, and checking their capital levels is an important part of this.
What exactly is bank capital? How does it keep banks safe? And what are the levels of capital banks need to hold?
What is capital?
Put simply, capital is the money that a bank has obtained from its shareholders and other investors and any profit that it has made and not paid out. Consequently, if a bank wants to expand its capital base, it can do so for example by issuing more shares or retaining profits, rather than paying them out as dividends to shareholders.
Overall, every bank has two sources of funds: capital and debt. Debt is the money that it has borrowed from its lenders and will have to pay back. Debt includes among other things deposits from customers, debt securities issued and loans taken out by the bank.
Funds from these two sources are employed by the bank in a number of ways, for example to give loans to customers or to make other investments. These loans and other investments are the bank’s assets, along with funds that are held as cash.
How does capital keep banks safe?
Capital acts like a financial cushion against losses. When, for example, many borrowers are suddenly unable to pay back their loans, or some of the bank’s investments fall in value, the bank will make a loss and without a capital cushion might even go bankrupt. However, if it has a solid capital base, it will use it to absorb the loss and continue to operate and serve its customers.
How much capital do banks need to hold?
In European banking supervision, the capital requirements for a bank consist of three main elements:
- minimum capital requirements, known as Pillar 1 requirements
- an additional capital requirement, known as the Pillar 2 requirement
- buffer requirements
First, all banks under European banking supervision have to comply with the European law that sets the minimum total capital requirement (called Pillar 1 requirement) at 8% of banks’ risk-weighted assets. But what are risk-weighted assets? They are the total assets a bank has, multiplied by their respective risk factors (risk weights). Risk factors reflect how risky a certain asset type is perceived to be. The less risky an asset, the lower its risk-weighted asset amount and the less capital a bank needs to hold to cover for it. For example, a mortgage loan that is secured with collateral (a flat or a house) is less risky – has a lower risk factor – than a loan that is unsecured. As a result, a bank needs to hold less capital to cover for such a mortgage loan than it does to cover for an unsecured loan.
Second, there is the additional capital requirement set by supervisors (called the Pillar 2 requirement). This is where European banking supervision comes in. Supervisors from the ECB and the supervisory authorities of participating countries look at individual banks in detail and assess the risks that each of them is exposed to. They do this via an annual Supervisory Review and Evaluation Process (SREP). If the supervisors conclude that the bank’s risks are not sufficiently covered by minimum capital requirements, they ask it to hold additional capital.
Both minimum and additional capital requirements are binding and there are legal consequences if they are not adhered to. These consequences depend on how serious the breach is. The supervisor may, for example, ask the bank to draw up a plan showing how it will restore its compliance with the capital requirements. Or, if the breach is very serious, the bank may lose its banking licence.
The third capital requirement for banks is that they have additional buffers for different purposes (for general conservation of capital and against cyclical and non-cyclical systemic risk).
In addition to these three sets of capital requirements, supervisors expect banks to reserve certain amounts of capital for times of stress (this is called Pillar 2 guidance).
On top of the amounts regulators and supervisors demand, banks are expected to determine themselves how much capital they need to be able to sustainably follow their business models.
- Supervision. Explained. What is the SREP?
- Supervision. Explained. What is the targeted review of internal models?
FAQs
Capital regulations require banks to maintain a minimum level of equity per loan and other assets because of the nature of the risk under which they operate. This required minimum is designed for protection, allowing banks to sustain unanticipated losses.
Why is it necessary for banks to maintain adequate capital? ›
Adequate capital is critical to protect financial institutions' depositors and policyholders. Regulators set requirements on minimum capital to ensure financial institutions can absorb unexpected losses in their business. This is a core tool of prudential regulation and also supports system-level financial stability.
Why might a bank hold a lot of bank capital? ›
Banks decide for themselves, but regulators all over the world require banks to hold a certain amount of capital—calculated as a percentage of their assets—so they are less likely to fail, seek a government rescue, or trigger a financial crisis.
What are the reasons why capital is required? ›
Without enough capital, a company will struggle to maintain operations and cash flow. As a result, many businesses seek out financing to meet their capital needs. In fact, an estimated 56% of small businesses seek business funding at some point in time.
What is the main purpose of capital in banks? ›
(Source: Rand McNally Bankers Director, 1927.) Published March 8, 2024. A primary purpose of bank capital is to protect depositors from losses and banks from failure. Ensuring adequate capital has been a consistent historical priority of US banking regulators as part of their role in promoting a safe banking system.
What happens if a bank doesn't have enough capital? ›
“If a bank assumes too much risk in its investments or loan portfolio and realizes its losses, that could be a cause of the failure,” Meyer says. “If no additional capital is raised and the losses are severe enough, the regulators will assume the institution to sell or liquidate it.”
Why is capital adequacy so important to banks? ›
Highlights of Capital Adequacy Ratio (CAR)
At the time of winding up of the company, the depositors assets are more important than the company's own finances. CAR ensures that a layer of safety is present for the bank to manage its own risk weighted assets before it can manage its depositors' assets.
Why is having enough capital important? ›
Having adequate capital for business is important for several reasons. Firstly, capital helps establish confidence and attract deposits to fund operations, ensuring the business can continue. Secondly, capital acts as a cushion to absorb unforeseen losses, protecting the business from failure.
Why does bank capital matter? ›
Banks rely on both debt and capital to fund loans and other assets, but capital is what allows the bank to take a loss and keep on operating.
What is the capital requirement for banks? ›
a minimum CET1 capital ratio requirement of 4.5 percent, which is the same for each bank; the stress capital buffer (SCB) requirement, which is determined from the supervisory stress test results and is at least 2.5 percent;1 and.
In general, financial institutions place holds for two main reasons: First, they want to make sure that a deposit will clear as a way to protect themselves and, second, sometimes they'll place a hold on funds because they suspect fraud and are taking actions to protect the account holder.
Why are banks currently holding capital well above the minimum regulatory requirement? ›
When the amount of a bank's capital gets too low, and it can't get any more capital, the bank is likely to fail. So the more capital a bank has, the safer it is, and the more money it can stand to lose before going out of business. High levels of capital make depositors' funds safer.
Why is capital necessary? ›
How Capital Is Used. Capital is used by companies to pay for the ongoing production of goods and services to create profit. Companies use their capital to invest in all kinds of things to create value. Labor and building expansions are two common areas of capital allocation.
Why are capitals so important? ›
A capital is frequently a country's business, cultural, and population center. Capital cities are often historical centers of trade, communication, and transportation.
Why do banks raise capital? ›
Capital acts like a financial cushion against losses. When, for example, many borrowers are suddenly unable to pay back their loans, or some of the bank's investments fall in value, the bank will make a loss and without a capital cushion might even go bankrupt.
Why does a bank need a holding company? ›
A bank holding company is able to reduce overall risk by spreading its financial and legal liabilities among its subsidiary banks. Likewise, a bank holding company is able to move assets around strategically among its subsidiaries to increase profits and reduce risk.
Why do banks hold funds? ›
The hold allows us (and the bank paying the funds) time to validate the check – which can help you avoid potential fees in the event a deposited check is returned unpaid. Keep in mind, though, that a check may still be returned unpaid after funds have been made available to you.
