Magazine article Economic Trends

What Shape Is Commercial Bank Capital In?

Magazine article Economic Trends

What Shape Is Commercial Bank Capital In?

Article excerpt

03.22.13

Regulators require banks to maintain a certain level of capital. Those requirements are put into place to ensure that banks will have enough of a cushion to maintain their daily activities in the event of an unforeseen shock. Due to the nature of bank debt, regulators focus on bank capital--the difference between a banks assets and its liabilities--when they are overseeing the safety and soundness of individual banks and the banking system overall.

Bank debt differs from corporate debt because the U.S. government provides certain guarantees for people who hold bank debt. Programs such at the Federal Deposit Insurance Corporation (FDIC) reduce the incentives of debt holders to require higher interest rates from firms that partake in riskier behavior. So bank capital requirements are in place to provide adequate incentives to bank managers to manage the banks risk well.

Since 2009 the total liabilities of commercial banks have remained relatively steady, as total assets have slowly crept up over time. With the exception of the first quarter of 2012, the difference between total assets and liabilities has had an upward trend.

Bank capital is often defined in tiers or categories. Different tiers include shareholders' equity, retained earnings, reserves, hybrid capital instruments, and subordinated term debt. The minimum capital required is specified as a percentage of the risk-weighted assets of the bank. Tier 1 capital is the book value of a bank's stock plus its retained earnings. Tier 2 capital is loan-loss reserves, some preferred stock, and subordinated debt. Total capital is the sum of Tier 1 and Tier 2 capital. Assets such as cash and equivalents and government securities are assigned a risk weight of zero. Yet interbank loans have a 0.2 risk weight, and mortgage loans have a risk weight of 0. …

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