What is bank capital?
The balance sheet of a commercial bank
Basic accounting identity:
Total bank assets = Total bank liabilities + Bank equity capital
Uses of funds Sources of funds
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The balance sheet of a commercial bank
Basic accounting identity:
Total bank assets = Total bank liabilities + Bank equity capital
Uses of funds Sources of funds
It’s misleading to say banks “hold” or “set aside” capital
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A typical commercial bank balance
sheet
Assets Liabilities + Net Worth
(Uses of funds) (Sources of funds)
Cash Deposits
Securities (e.g. bonds) Bonds
Loans Borrowings from other
Real Estate banks
Foreign Exchange
Other
Net worth = Equity =
Bank capital
Assets = Liabilities + Net worth/Capital 4
Balance sheet of US commercial banks
Percent of Total
Assets USD Billions
Assets
Cash items $3,346 14.6%
Securities $5,080 22.2%
Loans $12,201 53.3%
Other Assets $2,281 10.0%
TOTAL ASSETS $22,908 100.0%
Liabilities
Deposits $17,338 83.5%
Borrowings $2,337 11.3%
Other liabilities $1,081 5.2%
TOTAL LIABILITIES $20,756 100.0%
Net Worth = Bank Capital = Bank Assets - Bank Liabilities $2,152 9.4%
Source: FRED.
How big is the U.S. commercial banking system?
Commercial Banks $22.9 tr
GDP: $27.1 tr 5
What do we mean by “bank capital”?
There are two equivalent ways of defining bank “capital” or “equity”:
• As the difference between assets and liabilities:
Bank capital = Assets – Liabilities
• As funding that does not need to be repaid:
Bank capital = Common shares outstanding + retained
earnings
Key point: bank capital can absorb losses while the bank remains a going
concern – it is the bank’s own funds rather than borrowed money that has to
be repaid 6
How do we measure bank capital?
It seems straightforward: just subtract
liabilities from assets!
But it can be difficult to measure some assets
accurately:
• Should we use market values or
book/accounting values?
• Where the bank has derivative exposures,
the value of the “asset” depends on various
states of the world
• Some assets only have value while the bank
is solvent (eg goodwill, deferred tax assets)
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Effects of bank capital
• Banks have a larger cushion to absorb losses on their asset portfolio
without requiring a bail-out using public funds
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Example of solvency problems
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Example of solvency problems
Riskier assets => larger capital cushion required
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Effects of bank capital
• Banks have a larger cushion to absorb losses on their asset portfolio
without requiring a bail-out using public funds
• Bank owners have more “skin in the game”, which could curb
incentives for excessive risk-taking (See Holmstrom and Tirole (1997))
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Effects of bank capital
• Banks have a larger cushion to absorb losses on their asset portfolio
without requiring a bail-out using public funds
• Bank owners have more “skin in the game”, which could curb
incentives for excessive risk-taking (See Holmstrom and Tirole (1997))
• Equity capital is viewed as more costly than debt funding, so a higher
capital requirement may reduce lending
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