Everything you need to know about bank capital 

What is bank capital?

Bank capital is the value of a bank’s assets minus its liabilities – it effectively represents the net worth of the bank.

In this sense, bank capital is no different than the equity value of any non-bank corporation, which again is the difference between its assets and liabilities. However, because the business model of banks is very different, bank capital is an important metric for assessing the health of a bank and the banking sector as a whole.

One key distinction between banks and non-banks is that banks hold a much lower level of capital as a percentage of their total assets – this is otherwise known as leverage. Core banking businesses such as mortgage lending are relatively low-margin, and because banks have higher and more immediate liquidity needs than other companies (when depositors withdraw money, for example), they also hold other highly liquid assets on their balance sheets. Banks therefore generate relatively low returns on their asset base; to attract equity investors who expect returns at least comparable to other sectors of the market, banks use leverage to increase their profitability.

Another key distinction is the make-up of capital for banks and non-banks. For non-bank corporations, their capital consists mostly of paid-in capital (shareholder equity) plus retained earnings (profits that have not been paid out to shareholders). Banks’ capital also consists of paid-in capital and retained earnings (for banks this is known as common equity Tier 1 capital or CET1), but on top of this, regulators require banks to hold additional capital which is raised by selling subordinated instruments such as Additional Tier 1 (AT1) and Tier 2 bonds to investors.

Another difference between bank and corporate capital is the concept of risk-weighted assets (RWAs). In addition to holding minimum levels of capital against their total assets, some regulatory measures of bank capital are dictated by the mix of assets that banks hold; high quality mortgages carry lower capital requirements than certain types of corporate or personal unsecured lending, for example. 

Why do banks need capital?

Banks play an important role in the economy. They take deposits from the broader public, i.e. those who want to delay consumption and have excess savings, and channel them to individuals (borrowers) who need access to funds more immediately, be it for consumption (consumer loans, credit cards) or investment (mortgages, corporate loans).

In this system, the savers, at a minimum, always expect to get their money back. This is partly because the returns offered on the deposits tend to be low and certainly often lower than alternative destinations for cash such as money market funds, fixed income or equities. In other words, depositors expect to be taking a minimal level of risk, with the bank safely storing their funds for future consumption or investment down the line.

Banks will look to lend these deposits to their clients in the form of loans, in order to profit from the difference between the interest rate paid by borrowers and the rate the bank pays to depositors. Clearly, not all these loans will be repaid and during economic downturns, a higher percentage of the assets are expected to become impaired (the borrower falls behind on repayments or defaults on the loan). If we imagine a situation where a bank had very minimal or zero capital, and was almost exclusively funded through deposits with little other outstanding debt to take on losses first, then depositors may be next in line to take a hit.

In the aftermath of the global financial crisis, this risk to depositors in some cases became reality, and it has shaped banking regulation to this day. During the 2013 Cypriot financial crisis, for example, depositors with over €100,000 in the island's two largest banks – Bank of Cyprus and Laiki Bank – faced severe losses (or a "haircut") to fund a €10bn bailout. Uninsured depositors in Bank of Cyprus saw nearly 50% of their savings converted into equity, while those in Laiki Bank lost almost all their funds. ¹ 

A higher amount of capital could likely have prevented or significantly reduced the losses borne by depositors. In this context, bank capital serves as a second line of defence, with the first line of defence being the recurring profitability of the bank.

How have bank capital levels changed?

As we’ve said, by design, banks will always earn only a small return on their total assets. As a result, banks have a natural incentive to optimise the way in which they are deploying their depositors’ savings, so as to generate the highest return they possibly can to stay competitive vis-à-vis non-bank sectors in the eyes of shareholders.

At the extreme, if left unchecked (or poorly regulated), the likely outcome would be banks holding an ever lower amount of capital (equity) to maximise their headline return on equity. Indeed, this is precisely what occurred in the lead-up to the global financial crisis, which revealed that many banks were not robust enough to absorb increasing loan losses. This led to taxpayer-funded bailouts and public anger at the fact that most bank creditors escaped losses in the process.

In the years since, bank regulators globally have significantly increased the minimum level of capital (especially common equity) banks are required to hold and imposed stricter limits on leverage. Banks are therefore in a more comfortable position to address the next major downturn, when it happens. This does not mean they are immune to losses, but they are arguably in a better position to face a severe scenario than at any time in at least the last 20-30 years.

How much bank capital is enough?

If higher capital levels make banks financially more secure, then why aren’t banks required to hold even more capital than they currently do?

The answer is that with bank capital, there is a fine balance between achieving broader financial stability and maintaining the appeal of the banking sector to external investors vis-à-vis other sectors in the economy. If capital requirements were raised to what we might call ultra-safe levels – i.e. beyond the point where any additional impact on financial stability becomes negligible – equity investors could exit the sector in pursuit of better returns elsewhere. This would likely force banks to curtail their lending activities (a negative for the wider economy) and shrink the investor base for banks to raise additional capital when they needed it (a negative for financial stability).

Therefore, the “right” amount of capital across the sector is one that ensures broader financial stability (this does not guarantee zero bank failures and individual name selection is still very important) but also preserves the sector’s appeal to external investors vis-à-vis other alternatives.

Why does bank capital matter to fixed income investors?

Globally, banks issue billions of dollars in bonds across multiple currencies every year to fund their ongoing activities and optimise their balance sheets, and those invested in these bonds will have a keen interest in bank capital levels.

First, holders of bank capital instruments such as AT1s and Tier 2s are subject to the specific characteristics of these bonds, including built-in loss-absorbing mechanisms that can see bondholders either written down or converted to equity if the issuing institution gets into trouble (for a fuller explanation see our AT1 explainer here). Triggers for these features are tied to the bank’s capital levels, so an understanding of the sustainability of its capital position is essential.

Second, more generally fixed income investors may want to consider whether the amount of a bank’s core capital (or common equity), along with its profitability and general financial standing (such as its liquidity position) are adequate to deal with any potential losses on the asset side. That includes not just whether capital is merely sufficient to absorb losses, but perhaps more importantly, whether after these hypothetical losses the bank will continue to hold an amount of capital that underpins the trust of depositors. Absent this trust, any bank is likely to face a deposit run and an inevitable liquidity crisis, which can become existential.

1.  https://www.forbes.com/sites/timworstall/2013/03/31/theres-something-very-strange-about-the-cyprus-bank-haircut-very-strange-indeed/