The role of bank capital-fbi

Because even the best risk-management techniques cannot guarantee losses, banks cannot rely on deposits alone to fund their investments. Funding also comes from share owners’ equity, which means that bank managers must concern themselves with the value of the bank’s equity capital as well as the composition of the bank’s assets and liabilities.

A bank’s shareholders, however, are residual claimants, meaning that they may share in the bank’s profits but are also the first to bear any losses stemming from bad loans or failed investments. When the value of a bank’s assets declines, shareholders bear the loss, at least up to the point at which their shares become worthless, while depositors stand to suffer only if losses mount high enough to exhaust the bank’s equity, rendering the bank insolvent. In that case, the bank may be closed and its assets liquidated, with depositors (and, after them, if anything remains, other creditors) receiving prorated shares of the proceeds.

Where bank deposits are not insured or otherwise guaranteed by government authorities, bank equity capital serves as depositors’ principal source of security against bank losses.

Deposit guarantees, whether explicit (as with deposit insurance) or implicit (as when government authorities are expected to bail out failing banks), can have the unintended consequence of reducing a bank’s equity capital, for which such guarantees are a substitute. Regulators have in turn attempted to compensate for this effect by regulating bank capital. For example, the first (1988) and second (2004) Basel Accords (Basel I and Basel II), which were implemented within the European Union and, to a limited extent, in the United States, established minimum capital requirements for different banks based on formulas that attempted to account for the risks to which each is exposed.

Thus, Basel I established an 8 percent capital-to-asset ratio target, with bank assets weighted according to the risk of loss; weights ranged from zero (for top-rated government securities) to one (for some corporate bonds). Following the global financial crisis of 2008–09, a new agreement, known as Basel III (2010), increased capital requirements and imposed other safeguards in rules that would be implemented gradually through early 2019.

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