Understanding Bank Capital

Bank capital

Bank capital is the difference between a banks assets and its liabilities. It represents the new worth of the bank or its equity values to investors. The asset portion of a banks capital includes its cash, government securities, and interest earning loans (mortgages, letters of credit and inter-bank loans). The liabilities section of a bank's capital includes loan-loss reserves and any debt it owes. A bank's capital can be thought of as the margin to which creditors are covered if the bank would liquidate its assets.

Basel I, Basel II and Basel III standards provides a definition of the regulatory bank capital that market and banking regulators closely monitor. A banks capital can be divided or structured into different tiers - with Tier 1 capital the primary indicator of the banks financial health.

How does it work? 

Bank capital indicates the financial health of the bank. If an external force was take a hit on the bank (such as coronavirus of the financial crisis of 2008) it is the bank's capital that will determine if the bank would survive or go into insolvency. As aforementioned, Basil plays a central role on the regulations that banks must follow. Whilst bank capital can typically be defined as the difference between a banks assets and liabilities, regulators typically have a different definition.

As the financial crisis of 2008 indicated, banks play a crucial role in the economy by helping helping individuals or companies manage their money, achieve their financial goals or providing assistance if their financial health downturns. Consequently, banks typically face high levels of regulation. The most recent international banking regulatory accord of Basel III provides a framework for defining banking regulatory capital. Basel III compares a bank's assets with its capital to determine if the bank could stand the test of a crisis. Stress testing conducted by the Bank of England is a means of getting this done.

Following Basel III, regulatory bank capital can be divided into different tiers. From a regulators POV bank capital - and specifically that of tier one capital - is the core measure of the financial strength of a bank. Tiers are based on subordination and a banks ability to absorb losses with a sharp distinction of capital instruments when it is still solvent verses after it goes bankrupt.

What are the tiers?

Tier 1 Capital

Tier 1 capital includes CET1 and other financial instruments that are subordinated to subordinated debt, having no fixed maturity and no embedded incentive for redemption, for which a bank can cancel dividends or coupons at any time. Tier 1 capital is intended to measure a banks financial health and is depleted first when the bank faces losses without having to stop business operations. As the 2008 financial crisis showed, this is of fundamental importance.  

CET1 AKA common equity tier 1 is a component of the tier 1 capital. It mostly consists of cash, stock surpluses, retained earnings and common shares. It is a capital measure that was introduced in 2014 to protect the economy from a financial crisis. 

Another component of tier 1 capital includes Additional Tier 1 Capital. These are defined as instruments that are not common equity but are still eligible to be included in this tier. Examples of this can include contingent convertible or hybrid security , which has a perpetual term and can be converted into equity when a "trigger" occurs. A "trigger" event is one that causes a security to be converted into equity when the CET1 capital falls below a certain threshold. 

Contingent convertibles are debt instruments issued by European financial institutions. These works in a way similar to that of traditional convertible bonds. They have a specific 'strike price' (the set price of which a financial derivative can be bought or sold at when exercised) that if breached can result in the bond being transformed into equity or stock. Primary investors for these includes individual investors and private banks. They tend to be high-yield, high risk and are also known as Enhanced Capital Notes. 

Under Basel III the minimum tier 1 capital ratio is 10.5% - this is calculated by dividing the bank's tier 1 capital by its total risk-based assets. Let us consider a brief example. 

Bank XXX has tier 1 capital of £180bn and risk-weighted assets worth £1tn. So the bank's tier 1 capital ratio is £180bn / £1 trillion = 18% so the bank exceeds the minimum amount of tier 1 capital ratio required. 

Tier 2 Capital 

Components of Tier 2 capital includes revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves and undisclosed reserves. As tier 2 capital is less reliable than tier 1 capital and is more supplementary in nature it is considered to be more difficult to accurately calculate and is composed of assets that are more difficult to liquidate.   

In accordance with Basel III, the minimum total capital ratio is 12.9% - the minimum of tier 2 capital ratio is 2% in contrast with the 10.5% required for tier 1 capital. So if the bank in the example considered in Tier 1 Capital also holds £20bn of Tier 2 Capital whilst holding £1tn in RWA's then it meets exactly the minimum amount of tier 2 capital required. (20bn/1tn = 2%). Consequently, its total capital ratio would be 20% - significantly above its minimum total capital ratio of 12.9%. In this case, it is likely that the bank should be looking at ways to allocate more of its tier one capital efficiently as it is currently in a significant surplus - indicating a very high level of financial health.