What is regulatory capital for?
Banking is a risky business
Interest Rates: What if they plummet? Much harder to make money!
Loans: What if borrowers default? Or growth slows down?
Deposits: What if people start withdrawing money in a panic?
Industry: What if the bank’s main industry crashes?
Among all risks, loans are very risky because borrowers could default and banks must manage this risk to earn money, so banks in large part earn money by picking the right borrowers to lend to by assessing the risk properly and by charging them the correct rates, the correct interest rates on the money that they borrow. Nevertheless, people could default, pay back Loans late, “disappear”, etc. Banks need capital to cover those potential losses due to black swan events.
How does Regulatory Capital come into picture?
Under normal circumstances
Loans are one of the bank’s key Assets. What happens if many people suddenly default, and the bank must write down its Loans balance? Would you prefer the bank take all the money we deposited and use them to cover their losses? What will happen to stock market if the bank tells its lenders it can’t repay them? Under normal circumstances, the bank will use its shareholders’ equity as a buffer to cover losses on assets.
What if the bank “runs out” of shareholders’ equity?
If the bank “runs out” of shareholders’ equity, the banks must use other assets to cover losses, such as deposits or other funding sources.
No one would ever want this situation to happen. And the whole reason Regulatory Capital exists is because of the concept of unexpected losses. If there are unexpected huge impaired loans and the bank doesn’t have Regulatory Capital saved up, what would go down is one of these items under liabilities: customer deposits, other liabilities, subordinated debt, provisions due to banks.
Regulatory Capital – the solution
The solution is that a bank must use its equity to cover these losses or potential losses. Remember that equity represents the bank’s saved after-tax profits. All of these regulatory capital metrics and ratios are based on the bank’s equity. There are many variations of metrics and ratios, but this is the core principle behind all of these ideas.
A bank must always maintain a certain amount of regulatory capital. Not only is the amount important, but the liquidity and stability of that capital are also important. If a bank has a certain amount of capital on paper but can not access it quickly to cover sudden losses or overnight disasters, it’s not particularly useful.
The other implication is that a bank can grow only in relation to its capital. Because the bank must have enough capital to back up potential losses, it’s also paying more on its funding sources to support that growth. Thus, regulatory capital not only backs up the loans that bank has made, but it also constrains its growth and valuation. At the same time, regulatory capital will limit the dividends a bank can issue because dividends directly reduce equity.
How does Regulatory Capital cover losses?
- When an unexpected loss occurs, banks must increase their Allowance for Loan Losses
- How: They do this by increasing the Provision for Credit Losses, which reduces Net Income since it appears on the Income Statement
- And: That reduced Net Income reduces Shareholders’ Equity
- So Regulatory Capital “absorbs losses” by ensuring that Equity stays above a certain level, even if Net Income falls…
- And a dramatic drop in Net Income, would come from unexpected losses.
- Since a bank must record Provisions for Credit Losses when these unexpected losses occur, and it doesn’t have the required reserves
- Impact: The capital ratios fall when this happens.
Allowance for Loan Losses vs. Regulatory Capital
Allowance for Loan Losses
- For expected losses
- The bank has already assumed it will lose that amount on issued loans
- For unexpected losses
- What happens if something goes horribly wrong and the bank’s estimates are off?