Capital Reserve

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What is a 'Capital Reserve'

A capital reserve is a type of account on a municipality's or company's balance sheet that is reserved for long-term capital investment projects or other large and anticipated expenses that will be incurred in the future. For a bank or another financial institution, a capital reserve is set up to meet regulatory requirements and acts as a buffer during adverse economic times or financial hardship.

BREAKING DOWN 'Capital Reserve'

A capital reserve can be a type of reserve fund that is set aside to ensure that a company or municipality has adequate funding to at least partially finance an investment project. Contributions to the capital reserve account can be made from government subsidies or donated funds, or they can be set aside from the firm's or municipality's regular revenue-generating operations. Companies can also create capital reserves by selling relatively illiquid assets, such as equipment, real estate or intellectual property. Once recorded on the reporting entity's balance sheet, these funds are only to be spent on the capital expenditure projects for which they were initially intended, excluding any unforeseen circumstances. The funds constituting the capital reserve account are not used to pay dividends, repurchase shares or engage in other capital return programs.

Capital Reserve Example

An automobile manufacturer wants to build a new plant to expand production of its cars, and it plans to start building the plant a year from now. To have sufficient funds to begin construction, the company sets aside $10 million in cash, recognizing it on the balance sheet as a capital reserve. Once construction begins, the company draws from that capital reserve and recognizes the decrease in the capital reserve on the balance sheet and the corresponding new plant being constructed as an asset.

Capital Reserve for the Financial Sector

Capital reserves help banks finance their ongoing operations, but they also diminish the impact of a drop in asset values and act as a buffer against losses. Banks can set aside capital reserves to absorb losses in the event of anticipated losses on their loan books, for example. Capital reserves for banks can also provide protection for depositors not otherwise protected by insurance or government programs, such as the Federal Deposit Insurance Corporation (FDIC), as well as creditors. Capital reserves prevent banks and other financial institutions from failing during times of financial distress brought on by financial panics, liquidity crunches or recession.

Minimum capital reserves are often required by legislation and international agreements, such as the Dodd-Frank Act and the Basel Accords. The capital reserves required are usually expressed as ratios of a financial institution's total assets, tangible assets or risk-weighted assets. These ratios help convey whether financial institutions have the financial health to withstand financial hardship, particularly in terms of liquidity and solvency.