Banks need to have shock absorbers to cover unexpected losses, as and when they arise. This guide explains how banks have ‘capital’ for precisely this reason – to absorb shocks. It also explains how banks can increase the amount of capital they have.
Why do banks need shock absorbers?
Is it okay for banks to make losses?
Basically, yes it is.
That might sound surprising, but losses are, in fact, an unavoidable part of the business of banking. Banks offer various services to customers such as accepting deposits and providing credit such as mortgages or credit card loans. Lending is profitable because a bank will charge a higher interest rate on loans than the rate it pays out on your savings.
The problem is that some loans are never repaid – which can cause a bank to make a loss. Of course, the bank might expect some borrowers to default on their loans. And it factors this into its business by charging higher interest rates for more risky types of lending. But sometimes, more borrowers are unable to repay their debts than the bank had expected. And in such cases the bank might make a loss overall.
Of course, banks try to avoid losses – they need to be profitable to survive. But they cannot eliminate losses altogether. So instead they need to make sure that they have enough of a buffer to be able to withstand losses when they occur.
What happens when banks get into financial difficulties?
While making occasional losses is unavoidable, making big losses can lead to trouble for the bank itself and wider society. And if a bank makes too many big losses, it goes bust. This means that the bank can’t repay its creditors what it owes them.
The 2007-08 global financial crisis showed us what can go wrong when the banking system is too fragile. The Government had to bail out some UK banks, and many more, even if they didn’t go bust, got into severe financial difficulties. The UK economy suffered its deepest recession for 80 years, with very real costs for society:
Increase in the number of people without jobs
Fall in wages below 2007 levels
Bank lending ground to a complete halt
How do shock absorbers keep banks safe?
To cope with the possibility of losses, a bank must have enough capital. This is the money that the bank’s owners put on the line to absorb losses when they arise. Losses may result from loans that aren’t repaid or from other assets that fall in value (for instance, the securities that the bank holds).
So, in the same way the suspension on a motorbike softens the impact of bumps on the road, a bank’s capital absorbs losses when they arise. The more capital it has, the more it can absorb shocks.
Hugh Burns from the Bank of England’s Financial Stability area explains more about how banks get capital:
If a bank runs out of capital, it goes bust.
Because the costs of banks running into financial difficulties are so high, banks are regulated to make sure they have enough capital to keep them going – both in good times and bad.
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