Capital requirement (I)

Idea 3 August, text

Basel Accords

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).

Adding capital in hindsight

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.

Balance sheet with capital

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.

Two different limiting requirements

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:


See also Capital requirement (II).

Copyright © 2012 R. Harmsen. All rights reserved.

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