Now that you have a good idea about what capital is and the types of capital, you must be wondering why capital is so important. We’ve stated earlier that capital is used to absorb shocks during a bank’s worst periods.
Capital is important because it’s that part of an asset which can be used to repay its depositors, customers, and other claimants in case the bank doesn’t have enough liquidity due to losses it suffered in its operations. Capital doesn’t include any claims by bank equity holders.
Capital also helps the bank in times of a liquidity crisis. We talked about liquidity crises in our series on risks. Click here to learn more about liquidity crises and risks.
Look at the chart above. A large part of deposit in a bank is the floating deposit. Suppose that due to a reason such as a rumor or a poor economy, many of these depositors want their money back simultaneously. But a bank has already lent that money to those that are taking loans.
How does a bank pay back its depositors? It does so from the capital that the bank has. If the capital wasn’t there, then the bank would have no money to pay off its depositors and would have to declare bankruptcy. Once the situation becomes normal, the bank can resume its operations.
A strong capital base is an indicator of a bank’s strength to depositors and investors. A strong bank will attract more deposits. Also, its equity offering will fetch high subscriptions and high issue prices.
Banks like JP Morgan (JPM), Goldman Sachs (GS), Morgan Stanley (MS), Wells Fargo (WFC), and other banks in an ETF like the Financial Select Sector SPDR Fund (XLF) all hold good capital level to make themselves attractive to depositors and investors.
Capital ratio is also known as capital adequacy ratio or capital-to-risk-weighted assets ratio. Capital ratio is nothing but the ratio of capital a bank has divided by its risk-weighted assets. The capital includes both tier one and tier two capital.
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