When a financial system is hit by unforeseen, adverse events, bank capital is the first line of defense. Assuming the balance sheet isn’t fake (a la Groucho Marx), capital, or net worth, is the owners’ stake in the bank. Profits and losses from a bank’s activities alter its net worth, guiding investment and risk-taking. If losses wipe out its capital, the bank becomes insolvent – its assets are inadequate to cover its fixed liabilities – and typically fails.
Capital helps discipline all firms, banks included. A bank manages its assets and fixed liabilities in order to maximize profits and boost its net worth. It controls risk-taking to satisfy its owners, the holders of its equity. The simple diagram below shows the balance sheet of a bank with $100 in assets, $90 in fixed liabilities, and $10 in net worth or capital. Looking at it, the most important thing to keep in mind is that equity – the claim of shareholders to the bank’s net worth – is a contingent liability. It is the bank owners’ net claim on the bank once it pays its fixed liability holders. In essence, the calculation of capital is simple arithmetic: the subtraction of the fixed liabilities from the value of its assets.
A Simple Bank: Assets = Fixed Liabilities + Net Worth
Banks are far more reliant on debt than other firms. In the United States, recent measures of leverage (the ratio of assets to net worth) for the non-financial sector range from 1.8 (from the Federal Reserve's financial accounts data as of mid-2014) to as high as 3.5 (from the IRS 2011 Corporation Income Tax Returns), but all these measures are well below the leverage of the financial sector. For commercial banks, the leverage ratio is nearly 9 (from the Federal Reserve's H.8 report). That is, on average, banks have $8.00 of debt for each $1.00 of equity, while non-financial firms borrow between $0.80 and $2.50 for each $1.00 of net worth.
Several factors encourage banks to use so much debt finance. First, as providers of liquidity, banks typically issue short-term deposits at low cost. Second, bank owners benefit from explicit and implicit government guarantees (think deposit insurance and “too big to fail”) that allow them to pay a relatively low interest rate on their fixed liabilities. Third, bank owners are reluctant to issue more equity if the benefits primarily protect debt holders from losses in bankruptcy. While this “debt overhang” problem applies to any heavily indebted firm, it is usually bigger for banks because of their cheap debt finance.
But bank capital is fundamental to the safety of the financial system because one bank’s problems can quickly spread. When a large, complex, interconnected bank becomes insolvent (or a group of smaller, but similar banks fail), contagion can lead to fire sales and a panic that undermines the supply of credit and damages the entire economy. To avoid the crisis that would result, systemic banks need a large cushion against unforeseen losses in the value of their assets that could precipitate stress or even failure. That cushion is capital.
All of this is reasonably straightforward, at least in theory. In practice, however, things are more complicated. Perhaps surprisingly, a key challenge is defining and measuring the amount of bank capital that is available as a cushion against unforeseen losses that threaten bank insolvency.
To understand where the difficulties lie, it is useful to distinguish two very different issues. Referring back to the diagram above, the first issue is to assess the net worth of the bank. Assuming that the value of fixed liabilities is relatively easy to calculate, this comes down to asking how to best measure the value of the assets (including numerous illiquid assets). The second big issue is understanding which liabilities will be loss absorbing if a bank were to fail.
Starting with the valuation of assets, we need to exclude those that necessarily lose their value if the bank is put into resolution. Groucho Marx might have called these “contingent assets” fake because in bad times – when it really matters – they are without value and add nothing to net worth. One example is a bank’s “goodwill” that includes the value of its brand and client relationships. A second is “deferred tax assets:” these are potential reductions in a bank’s future tax obligations (resulting from past bank losses) that are only valuable when the bank has a profitable future. Yet a third is bank cross-shareholdings of other banks’ equity: in a broad financial crisis, these also typically collapse in value.
The question of loss absorbency on the part of liabilities is also complicated. The simplest case is common equity. Equity can always safely absorb unforeseen losses from bank assets. If assets decline in value – say, because of a wave of mortgage defaults – the bank must write down the value of its equity in its accounting books; recall that the calculation of equity is purely the result of simple arithmetic. If there is sufficient equity to absorb the unforeseen losses, the bank remains solvent. Common equity also provides another element of flexibility: unlike debt liabilities that have fixed interest obligations that must be paid, banks can reduce or even halt dividend payments to shareholders whenever they choose. The loss absorbency of equity and the contingent nature of dividends explain why common equity plays such a large role in financial regulatory reforms.
Other liabilities are less well suited to absorb unforeseen losses safely. In the United States, banks sometimes issue “preferred equity” that (unlike common equity) bears a fixed dividend payment that the bank can delay in bad times. Among European banks, contingent convertible debt (or “CoCos”) – bonds that, as the name implies, convert into equity when a specified event occurs – has become popular in recent years. But the ability of CoCos to absorb losses depends on the nature of the conversion trigger. If the trigger is a drop in the market value of existing equity below a relatively high threshold value, CoCos could be used to keep the bank adequately capitalized in the face of an adverse shock to its assets. Finally, some observers believe that, in a crisis, the government could compel the holders of a bank’s long-term debt to accept writedowns or involuntary conversion into equity. In practice, however, governments seeking to mitigate a financial crisis often choose to bail out – rather than bail in – bank debtholders.
Many people (including some bankers and business reporters) misunderstand or misrepresent the role of bank capital and, especially, of common equity. They sometimes refer to “holding equity” as if it were an idle asset that substitutes for better uses of scarce bank resources, such as loans or investments. Not at all. Equity is simply an alternative to debt as a means of finance. As we said at the outset, it is best thought of as a contingent liability. [For a range of myths and mistaken claims about bank equity, see here.]
A bank that issues more equity can either use the newly raised funds to undertake more lending or it can pay down its fixed liabilities, retiring bonds or returning deposits. These actions ensure that its assets always equal the sum of its fixed liabilities and net worth. The issue for the bank owners (and for the government) is what share of the bank assets should be financed with equity, rather than with debt. As we recently described in a related post, that remains the most controversial question facing banking systems around the world.
Just how important is it to measure capital properly? Consider the European Central Bank’s recent assessment of 130 European banks. While the ECB exercise focused on the asset side, the rules allowed different national regulators to treat bank assets in different ways. Some regulators chose to include contingent assets when estimating the capital of their banks. Had bank net worth instead been defined using the stricter standard that the European Single Supervisory Mechanism will apply in the future, the results would have been markedly different. As shown in the following figure from the ECB report, some banks would have had their key capital ratio to risk-adjusted assets reduced by more than 10 percentage points! (The figure displays the impact of upcoming changes in the definition of capital on the ratio of capital to risk-weighted assets for the euro-area banks included in the ECB assessment. Numbers above zero indicate that the capital ratio will fall by this amount once the new, more rigorous, regulations are fully phased in.)
The good news is that – by making these measurement differences transparent – the ECB is setting the stage for a stricter regime of capital supervision in the future. The bad news is that the euro area still has far to go to make its financial system safe.
So, what are the capital takeaways? Here are three: first, capital is the shock absorber that allows a bank to withstand losses and keep going. Second, because capital is the difference between the value of the bank’s assets and liabilities, accurate measurement is difficult. Third, and most important, learn from Groucho Marx: watch out for those who fake it. They put the entire financial system at risk.
Acknowledgment: We thank Larry White for his extensive comments. All errors in the post are, of course, ours.