Thursday, July 11, 2013

What Is A Bank? And Why Do They Resist Holding More Capital.

What is a bank?  The simplest definition is that banks borrow money short term, at low interest rates, and they lend it out longer term, at higher interest rates.  The money that they borrow by taking deposits, or other forms of borrowing, are liabilities to a bank.  The loans that they make are assets.  Banks are insolvent when their liabilities exceed the value of their assets.  To protect themselves from insolvency banks hold capital, or equity, that can be used to compensate for any losses that they might incur from the assets that they hold.  Their assets lose value when the risk of default increases. The ratio of assets that banks hold in relation to their assets has become an issue since bank regulators want to increase that ratio to avoid future banking crises.  If banks held more capital or equity they would be more able to deal with a decline in the value of the assets that they hold.  

Banks don't want to increase their capital to asset ratios because that reduces their leverage.  Banks are measured on the profits that they earn in relation to the capital or equity that they hold.  If they are required to hold more capital they have less leverage, and their return on equity will be lower at the same level of profit.  Bank executives are compensated primarily on the return that they earn on the equity that they hold.  They argue that higher capital ratios would increase their costs and reduce the amount of lending that they do.  Bank regulators don't buy that argument and they want to reduce the risk of insolvency in order to avoid the next banking crisis.  The only certain outcome from this debate is that banks will spend more money lobbying regulators and politicians against the need for higher capital ratios.

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