Regulators are butting heads with banks this week over capital, with new rules on the table that could force banks to hold more of it. But what exactly is capital, and why is it so important?
The question
gets at the heart of the state of finance today. In the crisis, a lack of
capital brought some banks to the brink. Now, by requiring banks to bolster
their capital, the government is trying to eliminate the need for taxpayer
bailouts in the future.
Though capital
is a centerpiece of Wall Street regulation, it resists a simple definition. Capital is
often described as a cushion that banks hold against losses. That’s true, but
the implications are not always clear. One unfortunate misconception that can
arise is that capital is a “rainy day fund.”
To understand
capital, think about how a financial firm does business. In a typical
transaction, a firm makes an investment, and it pays for that investment with a
combination of debt and equity. The more debt, or leverage, that finances the
transaction, the more money the firm can make (or lose).
Say a firm
pays for its investments with nine parts borrowing and one part equity. The
firm cares about the return it makes on its equity. By using debt, it can magnify
that return.
This is a principle banks use when determining how to
finance their operations.
A bank’s
capital is analogous to equity in the above example. More capital (so, less
debt) means banks are more able to withstand losses. But it also means they
can’t make as much money. This dynamic –
more capital leading to lower returns – helps explain why banks tend to argue
that holding more capital is “expensive.”
But even banks
won’t deny that capital is essential. Without it, the tiniest loss would put a
bank out of business. Think about
capital this way: It designates the percentage of assets that a bank can stand
to lose without becoming insolvent. If a bank’s
assets decline in value, it has to account for that by adjusting the source of
financing that it used. Liabilities like debt and deposits can’t be reduced, as
they represent money that the bank has promised to pay to bondholders or
depositors. But what’s
useful about capital is that it can be reduced, or written down. That’s the
whole point. Shareholders, who contribute to capital, agree to absorb losses if
the bank falls on hard times.
So, rather
than a “rainy day fund,” capital is a measure of a bank’s potential to absorb
losses.
How does a
bank increase its capital? There are few ways to do this, none of which banks
particularly love. One is for banks to retain more of their profit, and not pay
it out as dividends or spend it on share buybacks.
Another is to
sell more shares in the market. That’s generally unappealing to banks because
the shares would likely be sold at a discount, and the slug of new shares could
cause other shareholders to have their ownership stakes diluted. A third method
is reducing assets. This doesn’t actually increase the nominal level of
capital. But it does increase ratio of capital to assets, which is one way that
regulators measure the adequacy of a bank’s capital. If banks sell some of the
things they own, that can have the effect of bolstering capital ratios.
When banks
threaten to reduce lending or sell assets if they are forced to raise capital,
this is the dynamic they are referring to. The issue is
complicated enough as it is, without the political posturing that is taking
place. As regulators tinker with the rules, an understanding of capital will
help reveal what’s at stake.
A New York Times articles cited on Bloomberg - 10th July 2013.
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