5.18: Bank Capital

Banks are unique among businesses because they operate with a mix of owners’ funds, customer deposits, and borrowed money. While deposits are the most familiar source of funds, every bank must begin with an initial funding provided by its owners—known as bank capital or shareholders’ equity. This capital is not just a start-up requirement; it is also a key measure of a bank’s financial health.

Capital as a Loss Absorber

When a bank makes loans, buys government securities, or invests in buildings and technology, it uses a combination of capital and borrowed funds. If some assets lose value—such as when loans become nonperforming—the loss is absorbed first by the bank’s capital. This design protects depositors and other creditors, as their claims are settled before any distribution to shareholders. If losses exceed the available capital, the bank becomes insolvent, prompting regulatory intervention.

Regulatory Oversight and Capital Adequacy

To safeguard the banking system, regulators such as the Federal Reserve impose minimum capital requirements, often expressed as capital ratios. One key measure is the Common Equity Tier 1 (CET1) ratio, which compares high-quality capital—primarily common stock and retained earnings—to risk-weighted assets. Higher capital ratios provide a stronger buffer against unexpected losses.

If a bank’s capital falls below required thresholds, regulators can take corrective actions such as halting dividend payments, limiting asset growth, or requiring a capital restoration plan. These measures aim to preserve confidence, maintain stability in the financial system, and protect depositors from loss.

In essence, bank capital is both the foundation for a bank’s operations and its first line of defense against insolvency.

A bank doesn’t begin solely with customer deposits. It needs money from its owners to get started. This is known as bank capital or owners’ equity.

Let’s consider a hypothetical example. A bank is launched with capital contributed by its owners. It also collects deposits from customers and may borrow money from other banks or investors. All these funds are used to create assets.

These assets include loans issued, government securities bought, and physical infrastructure built.

Now, imagine some of those assets lose value, for example, if borrowers can’t repay their loans.

The bank still owes money to depositors and lenders. But the loss is first absorbed by the owners’ capital. If the loss is small, the bank can continue operating normally. But if it’s large enough to eliminate the capital, the bank becomes insolvent — meaning it no longer has enough assets to cover its liabilities.

To prevent such incidents, the Federal Reserve monitors capital levels closely. If a bank’s capital drops too low, the Fed can block dividend payments to shareholders, restrict risky lending, or demand a plan to restore capital.