What Is Bank Capital?
Bank capital is the difference between a bank's assets and its liabilities, and it represents the net worth of the bank or its equity value to investors. The asset portion of a bank's capital includes cash, government securities, and interest-earning loans (e.g., mortgages, letters of credit, and inter-bank loans). The liabilities section of a bank's capital includes loan-loss reserves and any debt it owes. A bank's capital can be thought of as the margin to which creditors are covered if the bank would liquidate 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.]
How Bank Capital Works
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 enacted by the Basel Committee on Banking Supervision through international accords of Basel I, Basel II, and Basel III. These standards provide a definition of the regulatory bank capital that market and banking regulators closely monitor.
Because banks serve an important role in the economy by collecting savings and channeling them to productive uses through loans, the banking industry and the definition of bank capital are heavily regulated. While each country can have its own requirements, the most recent international banking regulatory accord of Basel III provides a framework for defining regulatory bank capital.
According to Basel III, regulatory bank capital is divided into tiers. These are based on subordination and a bank's ability to absorb losses with a sharp distinction of capital instruments when it is still solvent versus after it goes bankrupt. Common equity tier 1 (CET1) includes the book value of common shares, paid-in capital, and retained earnings less goodwill and any other intangibles. Instruments within CET1 must have the highest subordination and no maturity.
Tier 1 Capital
Tier 1 capital includes CET1 plus other instruments that are subordinated to subordinated debt, have no fixed maturity and no embedded incentive for redemption, and for which a bank can cancel dividends or coupons at any time. Tier 1 capital consists of shareholders' equity and retained earnings. Tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations.
Tier 1 capital is the primary funding source of the bank. Typically, it holds nearly all of the bank's accumulated funds. These funds are generated specifically to support banks when losses are absorbed so that regular business functions do not have to be shut down.
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, assume there is a bank with tier 1 capital of $176.263 billion and risk-weighted assets worth $1.243 trillion. So the bank's tier 1 capital ratio for the period was $176.263 billion / $1.243 trillion = 14.18%, which met the minimum Basel III requirement of 10.5%.
Tier 2 Capital
Tier 2 capital consists of unsecured subordinated debt and its stock surplus with an original maturity of fewer than five years minus investments in non-consolidated financial institutions subsidiaries under certain circumstances. The total regulatory capital is equal to the sum of Tier 1 and Tier 2 capital.
Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves. Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to accurately calculate and is composed of assets that are more difficult to liquidate.
In 2019, under Basel III, the minimum total capital ratio is 12.9%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 10.9% for the tier 1 capital ratio. Assume that same bank reported tier 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%). Under Basel III, the bank met the minimum total capital ratio of 12.9%.
- Bank capital is the difference between a bank's assets and its liabilities, and it represents the net worth of the bank or its equity value to investors.
- Basel I, Basel II, and Basel III standards provide a definition of the regulatory bank capital that market and banking regulators closely monitor.
- Bank capital is segmented into tiers with Tier 1 capital the primary indicator a bank's health.
Book Value of Shareholders' Equity
The bank capital can be thought of as the book value of shareholders' equity on a bank's balance sheet. Because many banks revalue their financial assets more often than companies in other industries that hold fixed assets at a historical cost, shareholders' equity can serve as a reasonable proxy for the bank capital.
Typical items featured in the book value of shareholders' equity include preferred equity, common stock, and paid-in capital, retained earnings, and accumulated comprehensive income. The book value of shareholders' equity is also calculated as the difference between a bank's assets and liabilities.