Bank Capital: What Is It?

The difference between a bank’s assets and liabilities is known as bank capital, and it tells investors how much the bank is worth or its equity value. Cash, government securities, and interest-earning loans (such as mortgages, letters of credit, and interbank loans) make up a bank’s capital asset element. A bank’s loan-loss reserves and outstanding debt are included in the liabilities component of its capital. You may think of a bank’s capital as the amount that would cover its creditors in the event that it had to liquidate its assets.

The Operation of Bank Capital

Bank capital is a representation of the value of an equity instrument that a bank holds that has the lowest payment priority in the event of a bank liquidation and can withstand losses. Although the gap between a bank’s assets and liabilities is known as bank capital, national regulators define regulatory capital.

International standards adopted by the Basel Committee on Banking Supervision through the Basel I, Basel II, and Basel III international accords comprise the primary banking regulatory framework. These regulations define the regulatory bank capital that banking and market authorities closely monitor.

The banking sector and the meaning of bank capital are highly regulated since banks play a crucial role in the economy by gathering deposits and directing them toward loans for profitable endeavors. The most current international banking regulatory agreement, Basel III, offers a framework for determining regulatory bank capital; however, each nation may have its own standards.

Classifications of Regulatory Capital

Tiers of regulatory bank capital are established under Basel III. They are predicated on subordination and a bank’s capacity to withstand losses, with a clear differentiation between capital instruments issued. In contrast, the bank is solvent, and those issued after it files for bankruptcy. The book value of common shares, paid-in capital, and retained earnings—less goodwill and any other intangibles—make up standard equity tier 1 (CET1). CET1 instruments have to be the least mature and have the highest subordination.

First-Class Capital

Along with other instruments subordinated to subordinated debt, which have no set maturity and no inherent redemption incentive and for which a bank may cancel dividends or coupons at any moment, Tier 1 capital consists of CET1. Retained earnings and shareholders’ equity make up Tier 1 capital. Tier 1 capital is utilized when a bank sustains losses without stopping operations to gauge its financial health.

According to regulators, a bank’s financial health is the primary indicator of bank capital and Tier 1 capital.
The bank’s primary source of funding is its Tier 1 capital. It usually contains almost all of the bank’s total assets. These funds were created expressly to assist banks in covering their losses so that ongoing operations don’t have to be discontinued.

The minimum Tier 1 capital ratio required by Basel III is 8.5%. This ratio is computed by dividing the bank’s Tier 1 capital by the total risk-based assets. For example, a bank has risk-weighted assets of $1.243 trillion and tier 1 capital of $176.263 billion. The bank met the Basel III minimum requirements for tier 1 capital of 8.5% and a total capital ratio of 10.5%, with its tier 1 capital ratio for the period being $176.263 billion / $1.243 trillion = 14.18%.

Second-tier capital

Tier 2 capital comprises its stock surplus and unsecured subordinated debt with an initial term of less than five years or, in some instances, investments in non-consolidated financial institution subsidiaries. The combination of Tier 1 and Tier 2 capital represents the regulatory capital.

Revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and concealed reserves are all included in Tier 2 capital. Because tier 1 capital is more dependable than tier 2 capital, tier 2 capital is supplemental capital. Because it is more difficult to calculate precisely and comprises more difficult assets to liquidate, Tier 2 capital is seen as less trustworthy than Tier 1 capital.

There is no set need for tier 2 capital under Basel III; the minimum overall capital ratio is 10.5%.

Equity of Shareholders’ Book Value

On a bank’s balance sheet, the book value of shareholders’ equity is equivalent to the bank’s capital. Shareholders’ equity can be a good stand-in for bank capital since banks tend to revalue their financial assets more often than businesses in other sectors that own fixed assets at a historical cost.

The book value of shareholders’ equity typically includes the following items: common stock, paid-in capital, retained earnings, cumulative comprehensive income, and preferred equity. Another way to determine a bank’s book value of shareholders’ equity is to subtract its liabilities from its assets.

Conclusion

• The difference between a bank’s assets and liabilities is known as bank capital, and it tells investors how much the bank is worth or its equity value.
• Market and banking authorities carefully monitor the regulatory bank capital defined by the Basel I, Basel II, and Basel III criteria.
• The highest layer of bank capital, layer 1, primarily indicates a bank’s health.
• Since bank capital is the amount that would compensate creditors if the bank had to liquidate its assets, creditors are interested in knowing what a bank has.