What is bank capital?
Bank capital is the difference between a bank’s assets and liabilities, and it represents the bank’s net worth or its net worth to investors. The capital portion of a bank’s capital includes cash, government securities and interest-bearing loans (for example, mortgages, letters of credit and interbank loans). The capital liabilities section of a bank includes loan loss reserves and any debt it owes. The capital of a bank can be considered as the margin at which creditors are covered if the bank liquidates its assets.
[Important: From a regulator’s point of view, bank capital (and Tier 1 capital in particular) is the core measure of the financial strength of a bank.]
Functioning of bank capital
Bank capital represents the value of a bank’s equity instruments that can absorb losses and have the lowest priority in payments if the bank liquidates. While bank capital can be defined as the difference between a bank’s assets and liabilities, national authorities have their own definition of regulatory capital.
The main banking regulatory framework consists of international standards issued by the Basel Committee on Banking Supervision through international Basel I, Basel II and Basel III agreements. These standards provide a definition of regulatory banking capital that market and bank regulators closely monitor.
Because banks play an important role in the economy by collecting savings and channeling them to productive uses through loans, the banking sector and the definition of bank capital are highly regulated. Although each country may have its own requirements, the most recent Basel III international banking regulation agreement provides a framework for defining regulatory banking capital.
According to Basel III, regulatory banking capital is divided into several levels. These are based on subordination and the ability of a bank to absorb losses with a clear distinction from capital instruments when it is still solvent compared to bankruptcy. Core Tier 1 capital (CET1) includes the carrying value of common shares, paid-up capital and retained earnings minus goodwill and any other intangible assets. The instruments within CET1 must have the highest subordination and no maturity.
Level 1 capital
Tier 1 capital includes CET1 plus other instruments subordinated to subordinated debt, with no fixed maturity or integrated redemption incentive, and for which a bank can cancel dividends or coupons at any time. Category 1 capital consists of equity and retained earnings. Tier 1 capital is used to measure the financial health of a bank and is used when a bank has to absorb losses without ceasing its business activities.
Tier 1 capital is the bank’s main source of funding. Typically, it holds almost all of the funds accumulated by the bank. These funds are generated specifically to support banks when losses are absorbed, so regular business functions do not have to be closed.
Under Basel III, the minimum Tier 1 capital ratio is 10.5%, which is calculated by dividing the bank’s Tier 1 capital by its total risk-based assets. For example, suppose there is a bank with first-class capital of $ 176.263 billion and risk-weighted assets worth $ 1.243 trillion. The bank’s capital ratio for the period was therefore $ 176.263 billion / $ 1.243 trillion = 14.18%, which met the minimum Basel III requirement of 10.5%.
Level 2 capital
Category 2 capital consists of unsecured subordinated debt and its excess inventory with an initial maturity of less than five years less investments in subsidiaries of financial institutions that are not consolidated in certain circumstances. The total regulatory capital is equal to the sum of level 1 and level 2 capital.
Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general reserves for loan losses and undisclosed reserves. Level 2 capital is additional capital because it is less reliable than level 1 capital. Level 2 capital is considered less reliable than level 1 capital because it is more difficult to calculate with precision and is composed of assets more difficult to liquidate.
In 2019, under Basel III, the minimum total capital ratio is 12.9%, which indicates that the minimum level 2 capital ratio is 2%, compared to 10.9% for the level 1 capital ratio Suppose that this same bank declared level 2 capital of $ 32.526 billion. Its Tier 2 capital ratio for the quarter was $ 32.526 billion / $ 1.243 trillion = 2.62%. Thus, its total capital ratio was 16.8% (14.18% + 2.62%). Within the framework of Basel III, the bank respected the minimum total capital ratio of 12.9%.
Key points to remember
- Bank capital is the difference between a bank’s assets and liabilities, and it represents the bank’s net worth or its net worth to investors.
- The Basel I, Basel II and Basel III standards provide a definition of regulatory banking capital that market and bank regulators closely monitor.
- Bank capital is segmented into levels, level 1 capital being the main indicator of the health of a bank.
Book value of equity
Bank capital can be viewed as the book value of equity on a bank’s balance sheet. Since many banks revalue their financial assets more often than companies in other industries that hold capital assets at historical cost, equity can serve as a reasonable proxy for bank capital.
Typical items in the carrying amount of equity include preferred shares, common shares and paid-up capital, retained earnings and accumulated comprehensive income. The carrying amount of equity is also calculated as the difference between the assets and liabilities of a bank.