A strong economy needs a safe banking sector. And this, in turn, means that banks need to have enough capital. But how much is enough?
Keeping banks safe: how much capital is ‘enough’?
The greater the risks, the more capital required
As a previous guide explains, banks need to have capital: money that the bank’s owners put on the line to absorb losses, as and when they occur.
Banks are regulated to make sure they have enough capital to keep them going. In the UK, it’s the Bank of England’s role to regulate banks in this way. But how do we start to work out how much capital is ‘enough’?
To work out how much capital a bank needs, the first step is to add up all of its assets. These include all of the loans it has made (eg mortgages, personal loans, business loans, etc), all of its securities, and so on. These are all things on which it could make a loss. Note that capital itself is not an asset, instead it’s one way in which a bank is funded. By contrast, assets refer to all of the things the bank uses its funding for.
Then rules are put in place to make sure that a certain percentage of these assets are backed by capital to absorb potential losses. And the riskier the assets, the more capital a bank needs to have. A bank that offers very large loans relative to its borrowers’ incomes, for instance, would need to have more capital than a bank that lends exactly the same sized loans but to customers with much higher incomes. In the latter case, the lending is less risky as it’s less likely the borrowers would be unable to repay their debts.
How much capital do banks need to have?
The exact figure varies by institution. For instance, the world’s largest banks are required to hold more capital relative to their total assets than smaller banks. This is because of their potential to destabilise the entire financial system if they get into trouble.
What is clear, though, is that the current capital rules are much tougher than those in place before the 2007-08 financial crisis. Under the new rules, the world’s biggest banks need to have much more capital than before. This video from the Financial Stability Board, the international body that monitors and makes recommendations about the global financial system, explains this further:
In the UK, while the exact figure for capital requirements varies by bank, overall the banking sector is required to have capital equivalent to 13.5% of total “risk weighted” assets (that is, taking into account the riskiness of different types of assets, as discussed above).
How does stress testing support all of this?
But rules alone do not guarantee a safe and sound banking sector. We also carry out stress tests to assess how banks can cope with extreme economic scenarios:
All of this aims to keep the banking sector working in a safe and sound way. Even in a situation of financial stress, to avoid harm to the rest of the economy, it’s crucial that banks stay resilient and continue lending.
Does this mean the end of banks going bust?
No – while the system is safer than before, it needs to be remembered that even sizeable shock absorbers will not prevent any bank from ever going bust.
Banking regulation is not a ‘zero failure’ regime.
In fact, it is important that a bank can go bust – like any other company – if it runs into severe difficulties and is fundamentally not sustainable as a business. As another guide explains, though, when it comes to banks that do go bust, fundamental changes to regulation since the global crisis mean that it is the owners of the bank who foot the bill if a bank goes bust today, not the taxpayers.
Note: The 13.5% capital figure cited above is taken from the official record of the Bank of England’s Financial Policy Committee in March 2017. Note that the exact figure will vary depending, for instance, on the size and systemic importance of the bank in question.