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To illustrate the role of capital in banking, we consider a hypothetical small community bank named Deposits and Loans Corporation (DLC). DLC is primarily engaged in the traditional banking activities of taking deposits and making loans. A summary balance sheet for DLC at the end of 2015 is shown in Table 2.2 and a summary income statement for 2015 is shown in Table 2.3.

TABLE 2.2 Summary Balance Sheet for DLC at End of 2015 ($ millions)

Table 2.2 shows that the bank has $100 million of assets. Most of the assets (80 % of the total) are loans made by the bank to private individuals and small corporations. Cash and marketable securities account for a further 15 % of the assets. The remaining 5 % of the assets are fixed assets (i.e., buildings, equipment, etc.). A total of 90 % of the funding for the assets comes from deposits of one sort or another from the bank's customers. A further 5 % is financed by subordinated long-term debt. (These are bonds issued by the bank to investors that rank below deposits in the event of a liquidation.) The remaining 5 % is financed by the bank's shareholders in the form of equity capital. The equity capital consists of the original cash investment of the shareholders and earnings retained in the bank.

Consider next the income statement for 2015 shown in Table 2.3. The first item on the income statement is net interest income. This is the excess of the interest earned over the interest paid and is 3 % of the total assets in our example. It is important for the bank to be managed so that net interest income remains roughly constant regardless of movements in interest rates of different maturities. We will discuss this in more detail in Chapter 9.

TABLE 2.3 Summary Income Statement for DLC in 2015 ($ millions)

The next item is loan losses. This is 0.8 % of total assets for the year in question. Clearly it is very important for management to quantify credit risks and manage them carefully. But however carefully a bank assesses the financial health of its clients before making a loan, it is inevitable that some borrowers will default. This is what leads to loan losses. The percentage of loans that default will tend to fluctuate from year to year with economic conditions. It is likely that in some years default rates will be quite low, while in others they will be quite high.

The next item, non-interest income, consists of income from all the activities of the bank other than lending money. This includes fees for the services the bank provides for its clients. In the case of DLC non-interest income is 0.9 % of assets.

The final item is non-interest expense and is 2.5 % of assets in our example. This consists of all expenses other than interest paid. It includes salaries, technology-related costs, and other overheads. As in the case of all large businesses, these have a tendency to increase over time unless they are managed carefully. Banks must try to avoid large losses from litigation, business disruption, employee fraud, and so on. The risk associated with these types of losses is known as operational risk and will be discussed in Chapter 23.

Capital Adequacy

One measure of the performance of a bank is return on equity (ROE). Tables 2.2 and 2.3 show that the DLC's before-tax ROE is 0.6/5 or 12 %. If this is considered unsatisfactory, one way DLC might consider improving its ROE is by buying back its shares and replacing them with deposits so that equity financing is lower and ROE is higher. For example, if it moved to the balance sheet in Table 2.4 where equity is reduced to 1 % of assets and deposits are increased to 94 % of assets, its before-tax ROE would jump up to 60 %.

TABLE 2.4 Alternative Balance Sheet for DLC at End of 2015 with Equity Only 1 % of Assets ($ millions)

How much equity capital does DLC need? This question can be answered by hypothesizing an extremely adverse scenario and considering whether the bank would survive. Suppose that there is a severe recession and as a result the bank's loan losses rise by 3.2 % of assets to 4 % next year. (We assume that other items on the income statement in Table 2.3 are unaffected.) The result will be a pre-tax net operating loss of 2.6 % of assets (0.6 – 3.2 = −2.6). Assuming a tax rate of 30 %, this would result in an after-tax loss of about 1.8 % of assets.

In Table 2.2, equity capital is 5 % of assets and so an after-tax loss equal to 1.8 % of assets, although not at all welcome, can be absorbed. It would result in a reduction of the equity capital to 3.2 % of assets. Even a second bad year similar to the first would not totally wipe out the equity.

If DLC has moved to the more aggressive capital structure shown in Table 2.4, it is far less likely to survive. One year where the loan losses are 4 % of assets would totally wipe out equity capital and the bank would find itself in serious financial difficulties. It would no doubt try to raise additional equity capital, but it is likely to find this difficult when in such a weak financial position. It is possible that there would be a run on the bank (where all depositors decide to withdraw funds at the same time) and the bank would be forced into liquidation. If all assets could be liquidated for book value (a big assumption), the long-term debt-holders would likely receive about $4.2 million rather than $5 million (they would in effect absorb the negative equity) and the depositors would be repaid in full.

Clearly, it is inadequate for a bank to have only 1 % of assets funded by equity capital. Maintaining equity capital equal to 5 % of assets as in Table 2.2 is more reasonable. Note that equity and subordinated long-term debt are both sources of capital. Equity provides the best protection against adverse events. (In our example, when the bank has $5 million of equity capital rather than $1 million it stays solvent and is unlikely to be liquidated.) Subordinated long-term debt-holders rank below depositors in the event of default, but subordinated debt does not provide as good a cushion for the bank as equity because it does not prevent the bank's insolvency.

As we shall see in Chapters 15 to 17, bank regulators have tried to ensure that the capital a bank keeps is sufficient to cover the risks it takes. The risks include market risks, credit risks, and operational risks. Equity capital is categorized as “Tier 1 capital” while subordinated long-term debt is categorized as “Tier 2 capital.”