What Is Bank Capital, Anyway?

Regulators are butting heads with banks this week over capital, with new rules on the table that could force banks to hold more of it. But what exactly is capital, and why is it so important?

The question gets at the heart of finance today. In the crisis, a lack of capital brought some banks to the brink. Now, by requiring banks to bolster their capital, the government is trying to eliminate the need for taxpayer bailouts in the future.

Though capital is a centerpiece of Wall Street regulation, it resists a simple definition.

Capital is often described as a cushion that banks hold against losses. That's true, but the implications are not always clear. One unfortunate misconception that can arise is that capital is a “rainy day fund.”

To understand capital, think about how a financial firm does business. In a typical transaction, a firm pays for an investment with a combination of debt and equity. The more debt, or leverage, that finances the transaction, the more money the firm can make (or lose).

Say a firm pays for its investments with nine parts borrowing and one part equity. By using debt, the firm can magnify the return it makes on its equity. This is a principle banks use when determining how to finance their operations.

A bank's capital is analogous to equity in the above example. More capital (so, less debt) means banks are more able to withstand losses. But it also means they can't make as much money. This dynamic â€" more capital leading to lower returns â€" helps explain why banks tend to argue that holding more capital is “expensive.”

But even banks won't deny that capital is essential. Without it, the tiniest loss would put a bank out of business.

Think about capital this way: It designates the percentage of assets that a bank can stand to lose without becoming insolvent.

If a bank's assets decline in value, it has to account for that by adjusting the source of financing that it used. Liabilities like debt and deposits can't be reduced, as they represent money that the bank has promised to pay to bondholders or depositors.

But what's useful about capital is that it can be reduced, or written down. That's the whole point. Shareholders, who contribute to capital, agree to absorb losses if the bank falls on hard times. So, rather than a “rainy day fund,” capital is a measure of a bank's potential to absorb losses.

How does a bank increase its capital? There are few ways to do this, none of which banks particularly love. One is for banks to retain more of their profit, and not pay it out as dividends or spend it on share buybacks.

Another is to sell more shares in the market. That's generally unappealing to banks because the shares would very likely be sold at a discount, and the slug of new shares could dilute the stakes of other shareholders.

A third method is reducing assets. This doesn't actually increase the nominal level of capital. But it does increase ratio of capital to assets, which is one way that regulators measure the adequacy of a bank's capital. If banks sell some of the things they own, that can have the effect of bolstering capital ratios.

When banks threaten to reduce lending or sell assets if they are forced to raise capital, this is the dynamic they are referring to.

The issue is complicated enough as it is, without the political posturing that is taking place. As regulators tinker with the rules, an understanding of capital will help reveal what's at stake.