What is Capital? Part 1: Bank Capital

 

This is from The New York Times article Why Big Banks (and Some Odd Allies) Oppose a Plan to Protect Banks:

“Regulators are calling for an increase in the amount of capital — cash-like assets — that banks have to hold to tide them over in an emergency to avoid needing a taxpayer-funded bailout like the one in the 2008 financial crisis.”

 

No! No! No! No! No!

Bank capital is not “cash like assets.” Those are reserves. Reserves are money that banks keep either as cash or as deposits with other banks. They are cash like assets. And there are reserve requirements regarding the percentage of deposits that have to be kept as cash like assets, but those are not capital requirements.

A bank's capital is just the difference between the value of the bank’s assets and its liabilities. In other words, it is the equity the owners (shareholders) have in the bank. Capital requirements regulate the size of the capital. The most basic capital requirement is a leverage ratio, requiring that capital be equal to a certain percentage of assets.

Capital requirements are intended to deal with the threat of insolvency. A bank becomes insolvent when the value of its assets falls below the value of its liabilities, primarily the money it owes to depositors.

Why would the value of assets fall? The investments banks make are risky. The prices of securities that they buy, stocks or bonds, can go up, but they can also go down. If the bank owns stocks and bonds and the prices of those securities fall, the value of the bank’s assets falls. Part of the problem faced by Silicon Valley Bank was that it purchased a lot of long term bonds before interest rates started to increase, and as interest rates rose the price of those bonds fell. The loans banks make can also decrease in value. If the bank loans money to a person or a business and they do not repay the loan, the value of that asset (the loan) falls. In U.S. history, bank runs, (people racing to the bank to withdraw their money) tended to occur during economic downturns when falling security prices and failing businesses meant that the value of bank assets were declining. Under these circumstances people had greater reason to fear that some banks might become insolvent and not be able to repay their deposits. Capital helps protect against insolvency and banking crises.

Capital helps protect against insolvency by providing a cushion when asset prices fall. Assume you have $100,000 in assets, $80,000 in deposits and $20,000 capital, if the value of your assets falls by $15,000, you still have more than enough to cover all of your deposits. On the other hand, if you had $100,000 in assets, $90,000 in deposits and $10,000 capital, a decrease in value of $15,000 would leave the bank insolvent. In addition, it can be argued that banks have less incentive to take excessive risk when they have more of their own money at stake. They have more skin in the game.

Financial institutions, including banks, generally recognize the benefits of capital. I have written a lot about the history of New York City trust companies and one of the things they were most likely to mention in advertisements was the size of their capital. They called it capital and surplus, but it meant what we mean when we talk about a bank’s capital today. They used their capital to signal their strength and stability.

            There is, however, also a cost of higher capital: a lower rate of return. A higher capital requirement means that you have to rely more on bank owner’s money and less on borrowed funds (deposits). The extent to which you rely upon borrowed funds is called leverage. To see how leverage affects return on investment consider this example. You know of an investment that will return 10%. You have $100 you can invest. You do so and end up with $110, earning that 10% rate of return. Now imagine you can borrow another $100 from someone else at 5%. You now use their $100 and your investment of $100 for a total of $200. You get back the $200 plus 10% of 200, $220. You have to give the person you borrowed from $105, leaving you with $115. Your $100 investment now earned $15 for a 15% rate of return. That is the power of leverage. Of course if that investment you made doesn’t pay off we are back to worrying about insolvency. You still owe $105.

            So what is the story in the New York Times actually about. Its really about how complicated capital requirements can get. Toward the end of the article they point out that some suggested regulations could decrease certain kinds of lending. This is because capital requirements are no longer set based upon a simple leverage ratio that applies to everyone. Modern capital requirements recognize that not all investments are equal. Some are riskier than others. So regulations assign different risk assessments to different assets and then provide a risk weighted capital requirement. More risky assets, more capital. The argument of opponents of increased capital requirements is that these risk assessments could discourage banks from making some kinds of loans that we actually want to promote. In other words, it could get harder to get a mortgage to buy a home or take out a loan to start a business.

            I’m not going to try to answer which side is right. This isn’t about whether banks should have capital requirements, its about how much capital is enough. That is a hard question. My objective here has been to clarify what people are talking about when they are discussing banks and refer to capital. The post is titled part 1 because this is not the only meaning of capital. In other contexts, the meaning of capital is very different, and I plan to discuss that in the future. Who knows, eventually I might even take on the meaning of capitalism.