Loading the player...

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.

  1. Balance Sheet Reserves

    Balance sheet reserves are an amount expressed as a liability ...
  2. Reserve Requirements

    Reserve requirements refer to the amount of cash that banks must ...
  3. Bank Reserve

    A bank reserve is the currency deposit which is not lent out ...
  4. Asset Valuation Reserve - AVR

    When capital is set aside to help a company address unexpected ...
  5. Excess Reserves

    Excess reserves are capital reserves held by a bank or financial ...
  6. Wednesday Scramble

    Last-minute buying and selling of eligible reserves that takes ...
Related Articles
  1. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  2. Insights

    Banks Could Unlock Over $200 Billion for Investors

    Passage of a recently introduced Republican bill could free up $200 billion in bank capital.
  3. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  4. Investing

    What's the Salary of the Chairman of the Federal Reserve?

    The chairman of the Federal Reserve oversees the U.S. banking system.
  5. Investing

    Financial markets: Capital vs. Money Markets

    There are several key differences between capital markets and money markets as components of financial markets. Check out the similarities and differences between the two markets.
  6. Insights

    How the Federal Reserve Manages Money Supply

    Find out how the Federal Reserve manages bank reserves and how this contributes to a stable economy.
  1. Who determines the reserve ratio?

    Understand what the Federal Reserve is and what it regulates in the U.S. economy. Learn about the reserve ratio and how the ... Read Answer >>
  2. How are bank reserve requirements determined and how does this affect shareholders?

    Learn how bank reserve requirements are determined and how bank reserves affect shareholders through improved bank stability ... Read Answer >>
  3. What do banks do to control the bank reserve?

    Understand what the Federal Reserve does in order to expand or contract the economy. Learn what depository institutions can ... Read Answer >>
  4. What happens if the Federal Reserve lowers the reserve ratio?

    Learn about the Federal Reserve's monetary policy and the tools it uses to control it. Understand what happens if the Federal ... Read Answer >>
  5. Which nations' economies have reserve ratios?

    Learn more about the inconsistent imposition of depository banking reserve ratios, and why the United States stands alone ... Read Answer >>
  6. Why do commercial banks borrow from the Federal Reserve?

    Learn how commercial banks borrow from the Federal Reserve to meet minimum reserve requirements, and discover the pros and ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Liquidity

    Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's ...
  3. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  4. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  5. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  6. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
Trading Center