The Importance of Capital

Douglas J. Elliott
Douglas J. Elliott Former Brookings Expert, Partner - Oliver Wyman

January 28, 2010

In his State of the Union address, President Obama strongly urged Congress to send him solid banking reform legislation soon. Most experts agree reform should include higher capital requirements. Douglas Elliott explains the basics of capital in one paper, such as what it is, how it is defined, its role, as well as the relevant policy questions, such as what worked and what didn’t work during the crisis, whether banks can find a way to evade tougher requirements, and whether capital requirements should vary over the business cycle. In a second paper, he does a numerical analysis of the banking system’s probable responses to higher capital requirements in subsectors of the industry, its products, and its customers.

A Primer on Bank Capital

“Capital” is one of the most important concepts in banking. Unfortunately, it can be difficult for those outside the financial field to grasp, since there is no close analogy to capital in ordinary life. This primer is therefore intended to provide non-experts with a clear explanation of the basic facts about bank capital and a brief review of the related policy issues which are being debated as part of current proposals to reform the regulation of financial institutions.  Although aimed at non-experts, this primer is also intended as a useful reference tool for more knowledgeable analysts. This paper will not make policy recommendations, but attempts a neutral explanation of the range of expert views.

In its simplest form, capital represents the portion of a bank’s assets which have no associated contractual commitment for repayment. It is, therefore, available as a cushion in case the value of the bank’s assets declines or its liabilities rise. For example, if a bank has $100 of loans outstanding, funded by $92 of deposits and $8 of common stock invested by the bank’s owners, then this capital of $8 is available to protect the depositors against losses. If $7 worth of the loans were not repaid, there would still be more than enough money to pay back the depositors. The shareholders would suffer a nearly complete loss, but this is a considered a private matter, whereas there are strong public policy reasons to protect depositors.

If bank balance sheets were always accurate and banks always made profits, there would be no need for capital. Unfortunately, we do not live in that utopia, so a cushion of capital is necessary. Banks attempt to hold the minimum level of capital that supplies adequate protection, since capital is expensive, but all parties recognize the need for such a cushion even when they debate the right amount or form.

The recent financial crisis demonstrated again the critical importance of bank capital. As a result, virtually all proposals to reform regulation of financial institutions aim to increase the amount and quality of capital in the financial. This primer will answer the following key questions:

The Basics

What is capital and what role does it play?

What counts as capital and why?

Why are there different definitions of capital? When is each appropriate?

How much capital does a bank need?

Why do banks not hold a large amount of extra capital?

Who sets the regulatory requirements?

What are those regulatory requirements currently?

Why do capital standards vary around the world?

How do bank standards compare to capital requirements for other financial institutions?

What happens if a bank does not have enough capital?

How much capital do banks usually carry over the regulatory minimum? Why?

Do higher capital requirements always make banks safer?

What has been decided about regulatory changes?

What is the timetable for the remaining decisions?

Current Policy Issues

Why are policymakers proposing higher capital requirements?

What worked and what didn’t work during the crisis?

Will banks find a way to evade tougher requirements?

What are the negatives of higher bank capital requirements?

Should capital requirements vary over the business cycle?

What is “contingent capital”? Is it a good idea?

A Further Exploration of Bank Capital Requirements: Effects of Competition from Other Financial Sectors and Effects of Size of Bank or Borrower and of Loan Type

There is a strong consensus among policymakers that there need to be higher minimum capital requirements for banks in order to foster a more stable financial system and to help avoid the recurrence of a financial crisis of the magnitude of the recent one. However, higher capital requirements are not free – banks are likely to lend less, charge more for loans, and pay less on deposits as part of their actions to restore an acceptable return on the larger capital base they will need to employ. Determining the right minimum capital requirements therefore necessitates a careful balancing of the stability benefits against the economic costs of less attractive lending conditions.

Quantifying the likely effects on bank lending of different potential hikes in capital is a key step towards determining that balance. Elliott’s previous paper, “Quantifying the Effects on Lending of Increased Capital Requirements,” used a straightforward model of loan pricing behavior by banks in order to estimate the effects, which it found to be relatively small. This paper expands on those findings by examining a set of questions that were not fully addressed in the original paper due to time constraints.