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Capital requirement (II)

31 August – 1 September 2012

More realistic

As an illustration of how the capital requirement works, I present here a somewhat more realistic example of an extremely simplified balance sheet of a bank.

All amounts are in millions of euros, or billions, or dollars or pounds or whatever you like. The exact amounts are not the issue.

What matters are ratios, especially that between risk-bearing assets and the bank’s capital. That capital (equity) should be able to serve as a buffer, should unpleasant changes in the value of assets occur. That is why there are complicated rules that eventually set a minimum requirement for the bank’s equity.

Bank balance sheet example

Description Debit (assets) Credit (liabilities)
Stock capital 40
Reserves (retained earnings) 60
Cash reserves 100
Deposits 800
Loans 700
Mortgage-backed securities (MBS) 100

In the example, the capital consists of the money that shareholders invested in the bank (stock capital, 40 million) and the parts of the profits, which over the years were not paid as dividends, but kept in the bank as reserves (retained earnings, also known as retained income or retained profit(s); 60 million). 40 plus 60 makes 100 million in Tier 1 capital.

Securitisation

The risk bearing assets here consist of simple loans – that is the core business of a bank – and MBS’s. These are bonds in SPV’s (special purpose vehicles, special purpose entities), to which other banks sometimes sold their mortgage loans, in a proces called securitisation.

MBS’s were popular until about 2007, when suddenly everybody realised they could be quite risky so nobody wanted them anymore.

In such a situation, bookkeeping rules like GAAP or IFRS may require a downward revaluation. That means the book value of an asset is adjusted so it more accurately reflects the actual market value.

Let’s assume the MBS’s held by this bank lost half of their value, leading to this transaction:

Description Debit (assets) Credit (liabilities)
Mortgage-backed securities (MBS) 50
Revaluation costs 50

The revaluation costs lower the profits or cause a loss, which eventually diminishes the equity. Here I show the result as retained losses, so total equity (capital) goes from 100 ( = 40 + 60) to 50 ( = 40 + 60 − 50).

New balance sheet reflecting this:

Description Debit (assets) Credit (liabilities)
Stock capital 40
Reserves (retained earnings) 60
Retained losses 50
Cash reserves 100
Deposits 800
Loans 700
Mortgage-backed securities (MBS) 50

Checking the ratio

Before the revaluation, the risk-bearing assets totalled to 700 + 100 = 800. Capital was 40 + 60 = 100. The ratio is 100 / 800 = 12.5%, which is much higher than the usually required 8%.

After the revaluation, the risk-bearing assets total to 700 + 50 = 750. Capital is 40 + 60 − 50 = 50. The ratio is 50 / 750 = 6.7%, which is much lower than 8%. So the bank is in trouble. It no longer meets the capital requirement.

Bailout

The bank might be saved by a bailout, in which a government buys new preferred stock, or provides a subordinated loan.

The idea is that after a few years, the bank will have recovered enough so it can redeem the loan as agreed, or the government can gradually sell the shares to market parties at favourable prices.


Copyright © 2012 R. Harmsen. All rights reserved.

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