Understanding Bank Capital

Moneybox
A blog about business and economics.
July 10 2013 8:59 AM

What Is Bank Capital? It's Not Reserves, It's Not a Cushion, and You Don't Hold It

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Martin Gruenberg, chairman of the FDIC.

Photo by Saul Loeb/AFP/GettyImages

The FDIC and the Office of the Comptroller of the Currency are out this week with a proposal to impose stiffer capital requirements on America's largest banks. It's a very good idea, but it would cost the owners and managers of those big banks a lot of money, so there's going to be a lot of pushback. Complicating the issue in the eyes of the public is the fact that the idea of bank capital is often not well-explained in the media. You often hear language about banks being forced to "hold" capital or else somewhat hazy metaphors about the capital serving as a "cushion" against losses.

But even though measuring and regulating bank capital is quite complicated, explaining what it is is pretty simple.

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Think about a person buying a house. Such a person will typically have three different things going on. First there'll be a down payment that covers a fraction of the purchase price of the house. Second, there will be a loan from a bank that covers the rest of the purchase price. Last, a homebuyer typically has some money left over in his bank account after the down payment. In banking terms, that money left over is your "reserves" and it is useful because it provides liquidity and flexibility. If something happens, you can tap the reserves to pay for what you need rather than trying to sell your house. It's the down payment that's analagous to bank capital.

This isn't money that's "held" anywhere—you spent it on the house—the difference is that it's your own money rather than money you borrowed. And the essence of the issue is this. When you buy a house with a 5 percent down payment and then the house doubles in value you get more profit than you would have gotten had you bought the house with a 20 percent down payment. Conversely, when you buy a house with a 5 percent down payment and then the house declines in value by 6 percent, then you're under water on your mortgage, which wouldn't have happened had you made a 20 percent down payment.

So here's the issue. When a bank ends up under water—it owes more to its credits than it owns in investment value—you end up with a socially costly banking crisis. High capital requirements make crisis less likely because the very same bad investments that would bankrupt a heavily indebted bank fail to bankrupt a less indebted bank. Now the way banks often try to spin this is to argue that a bank somehow has a fixed quantity of capital, and requiring it to rely less on loans necessarily means less investment. But banks—just like you and me—have income. A bank like JPMorgan makes profits and then uses those profits to pay dividends. If the bank was hit with tougher capital rules then to make future investments it would have to rely more on its own money (in other words, profits earned in the previous year) and less on borrowed money, which would leave less money around to use for dividends. That's bad for Morgan's shareholders and it's bad for managers whose compensation package is linked to Morgan's share price, but it offers no reason for the bank to avoid making an otherwise promising investment.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.

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