Bank capital and why it is important

Since I will return to the subject of bank capital, it is probably worth spending a few lines describing what it is and why it is important.

You can’t start a bank—or any new enterprise, for that matter—without some start-up funds.  Or, as Gus Grissom says in The Right Stuff: “No bucks, no Buck Rogers.”

Prospective bankers have two potential sources of funds: borrowed money (i.e., debt); and funds put up by the owners (i.e., equity, also known as capital).  Since one of the main activities of banks is to take deposits, it would seem that banks could operate with almost no capital at all and rely instead on depositors’ money to conduct all of their business, such as making loans.  This might have a certain appeal to bank owners, since the less capital involved in the bank, the fewer shareholders with which to split any profits that might accrue to the bank.

And, in fact, banks are among the most highly leveraged firms in the United States, with an average debt-to-equity ratio of about nine to one in the middle of this decade.  By comparison, the average in manufacturing was about two to one and in agriculture about one to one.

Exclusive reliance on debt does have a downside, however.   Dividend payments to equity holders can be postponed or cancelled; debt service obligations cannot.  Since a large proportion of bank liabilities (demand deposits, and, in earlier times bank notes) is payable on demand, the inability to meet such withdrawals may lead to a sudden bank closure.

Banks therefore hold capital for several reasons.

  • It provides a buffer against a shortfall in cash flow, since dividends can be suspended without catastrophic consequences, which will free up money to pay depositors.
  • If a bank is forced to close, capital can be used to pay off unpaid debts.
  • Holding capital encourages banks to undertake less risk than they might under other circumstances, since capital is at risk in case of failure.
  • Because banks know more about the soundness of their operations than investors (what economists call information asymmetry), the decision to hold more capital and to subject owners to a greater loss in case of failure signals to depositors and potential investors that the bank will not undertake too much risk.
  • Because the government makes them.
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