Regulatory capital

Banks hold a special role in the economy. They function as intermediates between those who have money to spare and those who need money to invest. Basically those who have money to spare open saving accounts at banks. Banks lend that money to those who need it to invest. This is an extremely simplified version of reality but close enough for our purpose.

From the accountants point of view the money deposited at a bank are loans given to the bank. In other words they are liabilities. The loans given by banks are the banks investments. In other words they are assets. Below a simplified balance sheet of a bank is given.

Assets Liabilities
Cash and balances 10.000
Trading assets 50.000
Loans and receivables 500.000
Property and equipment 50.000
Equity 19.000
Amount due 450.000
Issued Bonds 135.000
Provision 6.000
Total Assets: 610.000 Total Liabilities: 610.000

Assets:

The “Cash and balances” represent the normal working capital necessary for maintaining a business. The “Trading assets” are short term investments in financial instruments like stocks, bonds, derivatives, bank-note’s, repo’s, etc. Many banks buy and sell such products for speculative profits or risk mitigation (hedging). “Loans and receivables” are the core business of a bank. They are the loans which have been given to customers (those who need money to invest). Most income is generated by the interest received on “Loans and receivables”. The “Property and equipment” are buildings etc.


Liabilities:

“Equity” is the portion of the banks balance sheet put up by the stockholders and increased through accrual of profits. There is no direct claim on the equity. In other words there is no obligation to repay the stockholders. The “Amount due” is the counterbalance of “Loans and receivables”. This is the money put at the bank by those who have too much (for instance the savings accounts). The “Loans and receivables” and “Amount due” represent the redistribution function of a bank. The bank is obliged to repay those accounts, although they remain fairly stable through time. The “Issued Bonds” is an extra source of long term money to bridge the gap between the “Loans and receivables” and the “Amount due” and to fund the additional investments. These bonds will mature, at which point the bank will have to repay the loan and find new money to fill the gap. The “Provision” can be seen as a reservoir to absorb losses.

A general risk in banking is the fact that occasionally people go broke, and fail to repay their loan. If this happens the value of “Loans and receivables” decreases. Fortunately there is no direct link between “Amount due” and “Loans and receivables”. If there were, you could lose your savings because some company you never heard of went broke. This is unacceptable; it would cause a bank run and destroy the economy. Therefore this risk is carried by the bank. The decrease in value has to be reflected somewhere in the liabilities in order to keep the total liabilities and assets equal. There are only two items available to the bank, “Equity” and “Provisions”. Luckily the “Provisions” reservoir has been created specifically to absorb these losses. Each year the credit losses (losses due to failed loans, or the decrease in the “Loans and receivables”) are subtracted from the provision. The provision is subsequently topped up by taking a provision from the profits.

The reservoir of provisions is made for a normal (expected) amount of losses due to lenders failing on their loan. A general provision is made based on the average historical percentage of loans that fail (the general provision). Furthermore a provision is made for specific loans which are considered in trouble (the specific provision).

History has shown that the reservoir is not always deep enough. The provision is based on credit losses under normal circumstances. However at some point abnormal circumstances will occur. Furthermore losses might occur due to different risks, like bad management. Abnormal credit losses occurred, for instance during the debt crisis in the eighties. So many large loans were failing that provisions fell short. The banks had to take the decreasing value of “Loans and receivables” by decreasing the value of the "Equity". This caused a lack of "Equity", which jeapordises the stabiltiy of the banks and the stability of the monetary system.

To ensure this would no longer be possible, it was determined that banks should have a minimum buffer of equity and provisions called the regulatory capital. The buffer means that a minimum amount of equity and provisions (regulatory capital) should be present for a bank given the value (and risk) of “Loans and receivables”. Or the other way around, a maximum amount of loans may be sold given the amount of equity and provisions. The size of the regulatory capital was determined by the Basel capital accord. The essence of this buffer was to ensure that a bank could absorb the losses sustained even in the most extreme circumstances.

Author: Muller, J.J.