What it means
A bank is unusual in that most of its funding comes from other people's money, largely customer deposits and borrowings. Capital is the slice funded by owners, and it is the slice that takes the hit first when loans go bad.
The reason regulators care so intensely is that bank failures spread. If a bank cannot repay depositors, confidence in other banks weakens, credit dries up and the damage runs well beyond the failed institution, which is why capital requirements are imposed rather than left to management judgement.
Not all capital is equally useful in a crisis. Common equity tier 1 capital, made up of ordinary shares and retained earnings, absorbs losses immediately and is the highest quality form, while other tiers such as subordinated debt only help in more extreme circumstances.
Capital requirements are expressed against risk-weighted assets rather than total assets, because a government bond and an unsecured business loan carry very different risks. A loan judged twice as risky counts twice as much when calculating how much capital the bank must hold against it.
There is a permanent tension in the system. More capital makes a bank safer but lowers return on equity, so bank management usually wants to run lean while supervisors want a thicker cushion, and the resulting negotiation shapes how much a bank can lend.
In practice
Real-world examples.
Example
A regional bank wants to grow its commercial loan book by $500 million. Because those loans carry a 100% risk weight, it must raise roughly $60 million of extra capital at a 12% target ratio, so it suspends its dividend for two quarters to retain earnings.
Example
A large bank passes its regulatory stress test with a projected minimum CET1 ratio of 9.4% and is permitted to resume share buybacks. A competitor that projects 6.8% is told to hold its capital instead.
Example
A bank shifts part of its portfolio from unsecured business lending into residential mortgages. The mortgages carry lower risk weights, so risk-weighted assets fall and the capital ratio improves without a dollar of new capital being raised.
Formula
Calculation
Bank capital = total assets - total liabilities
Common equity tier 1 ratio = CET1 capital / risk-weighted assets
An illustrative bank has total assets of $8,400 million, made up of loans, securities and cash, and total liabilities of $7,700 million, mostly customer deposits.
Bank capital = $8,400m - $7,700m = $700 million
Of that $700 million, $600 million qualifies as common equity tier 1 capital, with the remainder being other instruments. The bank's risk-weighted assets total $5,000 million, because much of its lending is secured on property and attracts a lower risk weight than its total balance sheet would suggest.
CET1 ratio = $600m / $5,000m = 12%
That comfortably exceeds a typical minimum requirement, which for many banks sits in the region of 8% to 10% once buffers are included. Now stress the picture: suppose a downturn causes $250 million of loan losses.
Remaining CET1 capital = $600m - $250m = $350 million
Stressed CET1 ratio = $350m / $5,000m = 7%
A single bad year has taken the bank from comfortable to below its likely requirement, which is exactly the kind of scenario supervisors run in their annual stress tests.Case study
Seen in the real world.
Alderfield Savings Bank is a fictional institution used here purely as an illustrative example. It ran with a CET1 ratio of 9%, just above its requirement, and its board resisted raising equity because doing so would dilute existing shareholders and depress return on equity.
When a regional employer closed and unemployment in its lending area rose, loan losses of $180 million against risk-weighted assets of $4,000 million cut the ratio to about 4.5%. The regulator restricted dividends and new lending, and the bank was forced to raise equity at a heavily discounted price, diluting shareholders far more than an earlier, voluntary raise would have.
The illustrative moral is that capital is cheapest to raise when you do not urgently need it. Alderfield's board optimised for return on equity in good years and paid for it many times over in the one bad year.
Watch out
Common mistakes.
- Thinking bank capital is a reserve of cash held in a vault, when it is a funding source recorded on the liabilities and equity side of the balance sheet.
- Comparing capital to total assets rather than risk-weighted assets, which makes banks with very different risk profiles look identical.
- Assuming a bank with plenty of capital cannot fail, when a solvent bank can still collapse if depositors withdraw faster than it can sell assets.
Questions
People also ask.
What is the difference between capital and liquidity?
Capital absorbs losses over time, while liquidity is the ability to meet withdrawals today, and a bank needs both to survive.
Why do banks resist holding more capital?
Because a bigger equity base spreads the same profit across more shareholders, lowering return on equity, which is a measure investors and executive pay schemes both watch closely.
Which capital ratio matters most?
The common equity tier 1 ratio is the one supervisors, analysts and rating agencies focus on, because it measures the capital that absorbs losses first and most reliably.
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