What Shape Is Commercial Bank Capital In?
Regulators require banks to maintain a certain level of capital. Those requirements are put into place to ensure that banks will have enough of a cushion to maintain their daily activities in the event of an unforeseen shock. Due to the nature of bank debt, regulators focus on bank capital—the difference between a bank’s assets and its liabilities—when they are overseeing the safety and soundness of individual banks and the banking system overall.
Bank debt differs from corporate debt because the U.S. government provides certain guarantees for people who hold bank debt. Programs such at the Federal Deposit Insurance Corporation (FDIC) reduce the incentives of debt holders to require higher interest rates from firms that partake in riskier behavior. So bank capital requirements are in place to provide adequate incentives to bank managers to manage the bank’s risk well.
Since 2009 the total liabilities of commercial banks have remained relatively steady, as total assets have slowly crept up over time. With the exception of the first quarter of 2012, the difference between total assets and liabilities has had an upward trend.
Bank capital is often defined in tiers or categories. Different tiers include shareholders' equity, retained earnings, reserves, hybrid capital instruments, and subordinated term debt. The minimum capital required is specified as a percentage of the risk-weighted assets of the bank. Tier 1 capital is the book value of a bank’s stock plus its retained earnings. Tier 2 capital is loan-loss reserves, some preferred stock, and subordinated debt. Total capital is the sum of Tier 1 and Tier 2 capital. Assets such as cash and equivalents and government securities are assigned a risk weight of zero. Yet interbank loans have a 0.2 risk weight, and mortgage loans have a risk weight of 0.5. Ordinary loans have a risk weight of 1.
The Basel Committee on Banking Supervision, created in 1974 by the central banks of the G-10 countries, sets capital ratio requirements to help standardize the banking sector worldwide. In 1989 the U.S. adopted these capital requirements (the so-called Basel I rules), established by the Bank for International Settlements. The Federal Reserve announced in December 2011 that it would implement substantially all of the more recent Basel III rules.
Basel III will require banks to hold 4.5 percent of common equity (up from 2 percent in Basel II) and 6 percent of Tier I capital (up from 4 percent in Basel II) of risk-weighted assets. It also introduces additional capital buffers, leverage ratios, and liquidity coverage ratios.
A bank's capital can be thought of as the margin to which creditors are covered if a bank liquidates its assets. Loan-loss reserves, or loan-loss provisions, are amounts set aside by banks to allow for any loss in the value of the loans they have on their books. Loan-loss reserves have been trending downward since the crisis. There is currently a debate about whether loan-loss reserves ought to be built up during boom years, the result of which could be an increase in future reserve requirements. Some policymakers are arguing that reserves typically fall during busts so that they are often too low during downturns. They see higher reserve requirements during recoveries as a way to give banks full coffers from which they could draw down during recessions.
Bank capital will be one of the most useful tools that regulators can use to avoid deep financial crises. The ongoing debate between the ability of banks to build capital while still extending credit will help shape the role of capital ratio requirements in the future.