Bank capital is the difference between a bank’s assets and its liabilities, representing the net worth of the bank or its equity value to investors. The asset portion of a bank’s capital includes cash, government securities, and interest-earning loans (e.g., mortgages, letters of credit, and inter-bank loans). The liabilities section of a bank’s capital includes loan-loss reserves and any debt it owes. A bank’s capital acts as a cushion for creditors in case the bank has to liquidate its assets.
Key Takeaways
- Bank capital is the difference between a bank’s assets and its liabilities, and it represents the net worth of the bank or its equity value to investors.
- International standards, like Basel I, Basel II, and Basel III, provide regulatory definitions of bank capital that are closely monitored by regulators.
- Bank capital is segmented into tiers with Tier 1 capital being the primary indicator of a bank’s health.
- Creditors look at a bank’s capital to evaluate the coverage in case of asset liquidation.
How Bank Capital Works
Bank capital represents the value of a bank’s equity instruments that can absorb losses and has the lowest priority in payments if the bank liquidates. While it can be defined as the difference between a bank’s assets and liabilities, many national authorities have their versions of regulatory capital definitions.
The principal banking regulatory framework consists of international standards enacted by the Basel Committee on Banking Supervision through accords like Basel I, Basel II, and Basel III. These standards define regulatory bank capital that market and banking authorities closely monitor.
Because banks play a crucial role in the economy by collecting savings and redirecting them through loans into productive uses, regulations surrounding bank capital are stringent. While each country might have its variations, Basel III remains a significant reference for defining regulatory bank capital.
Regulatory Capital Classifications
Tier 1 Capital
Tier 1 capital includes common equity tier 1 (CET1)—constituting the book value of common shares, paid-in capital, and retained earnings less goodwill and other intangibles. Instruments in CET1 must have the highest subordination and no maturity.
Tier 1 capital includes CET1 plus other instruments that are subordinated to standard debt, have no fixed maturity, and allow banks to cancel dividends or coupons unilaterally. Tier 1 capital mainly consists of shareholders’ equity and retained earnings.
Since it measures a bank’s financial health, Tier 1 capital is crucial when a bank must absorb losses without halting operations. According to Basel III, the minimum Tier 1 capital ratio is 8.5%, defined as the bank’s tier 1 capital divided by its total risk-weighted assets. For example, a bank with Tier 1 capital of $176.263 billion and risk-weighted assets of $1.243 trillion has a Tier 1 capital ratio of 14.18%, exceeding the Basel III minimum requirement of 8.5%.
Tier 2 Capital
Tier 2 capital comprises unsecured subordinated debt, revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and certain undisclosed reserves. It is supplementary because it is less reliable than Tier 1 capital and harder to liquidate.
Under Basel III, the minimum total capital ratio is 10.5%, comprising both Tier 1 and Tier 2 capital.
Book Value of Shareholders’ Equity
Bank capital is also the book value of shareholders’ equity on a bank’s balance sheet. Shareholders’ equity, often revalued more frequently in the banking sector than in other industries, can serve as an accurate proxy for bank capital.
Typical items in shareholders’ equity include preferred equity, common stock, paid-in capital, retained earnings, and accumulated comprehensive income. It’s calculated as the difference between a bank’s assets and liabilities.
By understanding the facets and importance of bank capital, investors and regulators can better gauge a bank’s financial health and preparedness in times of economic stress.
Related Terms: creditors, assets, liabilities, regulatory capital, financial strength.
References
- Basel Committee on Banking Supervision. “Basel III Monitoring Report” Page 27.
