Financial reporters often talk about “bank capital” as if all viewers know exactly what that term means. I have a feeling that not all viewers know what bank capital means and why it’s important.
Let’s say I want to start a bank. I take $1000 in deposits from Dan Depositor and make $1000 in a loan to Bob Borrower. In theory, I could do that. However, if Bob Borrower defaults on his loan, each dollar of loss on that loan would become a loss to Dad Depositor. Even a small loss (say, $10) would come directly out of Dan Depositor’s account. Being intelligent, Dan might like to avoid my bank.
You might say that my bank could purchase FDIC insurance using some of the interest on Bob Borrower’s loan. However, it wouldn’t take much of a loss before the FDIC were assuming losses.
So, as part of the regulatory infrastructure behind the banking industry, banks are required to meet minimum capital requirements. The capital required to back up each type of loan varies, but capital requirements are close to 10%. What this means is that for me to become a licensed bank that could make a loan of $1000 to Bob, I need to invest $100 of my own money in the bank. This provides a cushion where the shareholders (me) would have to risk losing all $100 of my investment in the bank before Dan Depositor is at risk of losing anything on his deposit. If Bob defaults and I sell his collateral for $800, the $200 loss first erodes my $100 (meaning my investment is now worthless), then the FDIC would be on the hook for the $100 difference.
If I wish to remain a bank, shareholders (me and whoever I can round up) would need to put up $200 more dollars. This is simply a regulatory requirement. If I fail to do this, banking regulators will sieze my deposits and loans.
September 27th, 2008 at 3:06 pm
Likewise, as we know, banks have often maintained excess capital and provide access to their excess capital reserves to other banks perhaps to meet their short term capital reserve requirements…the popular metric “overnight rates” refers to one example of excess bank capital lent short term. When this dries up for precautionary reasons, or borrowing cost increases due to demand exceeding supply, it can put immediate pressure on another tier of businesses down the line that would otherwise be healthier, importantly, mom and pops and larger corporations who use it for funding short-term/day-to-day needs such as payables and payroll. Then those institition’s customers/employees get squeezed, and so on and so on. Trickle-down recessionomics. The current short term bank-bank rates are “way high” due to both fear and lack of liquidity. The trickle down is just beginning.
October 2nd, 2008 at 8:46 am
[...] side, it has $10 billion in deposits, with a remaining $1 billion in shareholders equity (see Bank Capital [...]
October 7th, 2008 at 1:47 pm
[...] than they would pay to their expensive bank which had to carry the cost of branches and maintain capital reserves. The practice of going directly to securities markets for borrowing needs has the effect of [...]
October 17th, 2008 at 12:23 pm
I recently came upon this def: “Federal Funds: This is the shortest term money market instrument, available only to member institutions of the Federal Reserve System. Reserves held on deposit by member banks are called “Federal Funds.” A bank with excess reserves can lend them to a bank that is deficient, at the Federal Funds Rate. These loans are overnight and the interest rate is quite volatile, changing as the demand for reserves changes. The “effective” Federal Funds Rate gives an indication of the daily demand for reserves and is a daily average of many banks’ rates.”
While this has been the norm, this practice was blown out of the water of late due to a) reserves becoming deficient due to to covering devalued “marked to market” loans and b)sudden fundamental mistrust of each other by the banks. Now let’s see if I understand this…big banks, who’s biggest customers are each other, now won’t loan to each other because they don’t trust they will be paid back? Ok then, 2 questions: Why don’t they trust each other all of a sudden? And, why didn’t they stop sooner…why now?
2nd question first. Because they have years of profits derived from loaning each other short term funds and equities to cover (”I’ll lend you 5M IBM today at 1/16th if you lend me 10M GOOG at 1/32nd tomorrow”). Big infrastructures built up and big profit centers from simply scratching each other’s backs. Perhaps the rest of the answer is that the emperor has no clothes. Or to the point, they all knew what they were doing, knew it was risky, nee wrong, and did it anyway. (”If it’s good enough for Lehman, it’s good enough for us.”) When it finally came down to the short strokes, they said “no” to their brethren because they knew their brethren were in trouble… because everyone knew they all were originating or packaging or selling or buying the same bad loans. And nobody said anything.
A moment of introspection here: is Gecko still right?