Idea 3 August, text
So far, for the sake of simplicity, I ignored the capital requirement in my examples. (I said that before, in part 4 and part 10.) But such a requirement does in fact exist. So I add it now, starting from the situation in my article number 10.
Basel I (1988), Basel II (2004) and Basel III (2010–2011) are international accords about the capital requirement (and about a lot more).
The details are many and complicated. A shamelessly simplified summary is: banks must have at least 8 percent of their risk-weighted assets as capital (equity).
In reality, a bank starts with gathering capital from shareholders, before it becomes operative. In my example, I add capital afterwards, where none was present before.
That’s not normal, but I do this to correct what I knowingly left out before, to keep my examples as simple as possible.
By the end of my article 10, we had this situation:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Cash in bank | 100 | |
| Checking account (on demand) of Villager A | 100 | |
| Checking account (on demand) of Villager B | 900 | |
| Loan facility for Villager B | 900 |
Cash and reserves at the central bank are considered to be
risk-free, so the risk factor to be applied is 0%.
Consumer loans and unsecured commercial loans have a risk factor
of 100%. So in the example, the risk-weighted assets are:
0% * 100 + 100% * 900 = 900.
The required minimum capital is 8% of that, or 720 dollars.
I add a little more capital, and arrive at this balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Shareholders’ equity | 500 | |
| Subordinated loan from government | 300 | |
| Cash in bank | 100 | |
| Reserves with central bank | 800 | |
| Checking account (on demand) of Villager A | 100 | |
| Checking account (on demand) of Villager B | 900 | |
| Loan facility for Villager B | 900 |
Paid in shareholders’ equity (here 500) belongs to the so-called Tier 1 capital. I assumed that the bank has got into trouble before and has obtained a subordinated loan (300) from the government, provided in order to stabilize the bank (bailout).
Subordinated debt is a form of Tier 2 capital. Tier 1 and Tier 2 together count for the capital requirement, provided the ratio between the two is also OK.
I assumed that the money, which was paid in by the shareholders when the bank was founded, and the money of the subordinated loan, has eventually landed on an reserve account at the central bank. That means the bank has excess reserves: it has room for more loans than assumed before. But: such loans would mean new risky assets, so they must again be tested against the capital requirement.
The purpose of the capital requirement is to make sure that the bank has enough capital to be able to survive large depreciations of its assets, for example when many loans turn out to be bad debts.
Both requirements, the reserve requirement (see also part 1) and the capital requirement (this article, part 8), limit a bank’s potential to grant credits. But each requirement works in a different direction:
The reserve requirement means that a safe percentage of the bank’s account holders’ demand deposits (credit side, right side of the balance sheet) must be present as cash or central bank reserves (debit side, left side of the balance sheet).
The capital requirement means that a safe percentage of the bank’s risk-weighted assets (debit side, left side of the balance sheet) must be present as the total of Tier 1 and Tier 2 capital (credit side, right side of the balance sheet).
See also Capital requirement (II).
Copyright © 2012 R. Harmsen. All rights reserved.