Introduction to Bank Capital

Introduction to Bank Capital- A bank’s capital is the capital or equity put up by the bank’s heirs. The bank then takes in deposits or other debt liabilities and uses debt and equity to acquire assets, which means mainly making loans, but they also buy branches, ATMs, and computers. Importantly, capital is a source of funds that the bank uses to acquire assets. This means that, if a bank were to issue an extra dollar worth of equity or retain an additional dollar of earnings, it can use this to increase its holding of cash, securities, loans, or any other asset. When the bank finances additional assets with capital, its leverage ratio rises.

Role of bank capital

Bank capital acts as self-insurance, providing a buffer against insolvency and, so long as it is sufficiently positive, giving bank management an incentive to manage risk prudently. Automobile insurance is designed to create a similar incentive: auto owners bear part of the risk of accidents through deductibles and co-pays, which also motivate them to keep their vehicles road-ready and to drive safely.

a banking system that is short of capital can damage the broader economy in three ways. First, an undercapitalized bank is less able to supply credit to healthy borrowers. Second, weak banks may evergreen loans to zombie firms, adding unpaid interest to a loan’s principal to avoid taking losses and further undermining their already weak capital position. Finally, in the presence of a widespread capital shortfall, the system is more vulnerable to widespread panic.

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