How Much Capital Does a Bank Really Need?

There is an ongoing debate in the financial servic industry about how much capital banks really need. Regulators seek higher rather than lower capital ratios. But if a bank’s risk management goes haywire, and it loses public confidence, no amount of capital may save it.

Higher capital ratios come at a cost. This forces banks to manage their businesses to achieve a higher return to cover the higher cost of capital. To the extent that this encourages banks to assume higher levels of risk and therefore return, the higher capital ratios may become self-defeating.

How much capital a bank needs depends on how much risk it is taking. If its risks are low and well diversified then it should need less capital to support those risks than a bank that assumes a higher level of risks concentrated in a small number of risk weighted assets.

The financial crisis occurred partly because some banks combined very low levels of equity with very high levels of risk. The Regulators have tried to solve this problem by having all banks maintain a certain minimum level of capital both in terms of quantity and quality. But that typically means that all banks end up with similar capital ratios, even though they may have vastly different risk management portfolios.

For example, the largest U.S. banks today have similar tier one capital ratios, but vastly different exposures to the mortgage market.

But banks face other risks as well, not just in their loan portfolios, but in the way they manage their business. Risks such as funding, operations, disruption, disintermediation, systemic market factors and the loss of critical IP to name but a few.

All these risks have to be provided for to get a true estimate of the amount of economic capital banks need to support their business. The risks banks incur should drive the amount of capital they need and not vice versa.

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