Bank Capital and Profit

Question

I am struggling a bit with understanding the meaning of capital ratios, and bank profitablity. It seems to me that capital requirements stipulate that a certain fraction of banks' risk weighted assets have to be held as equity. I get why that is the case: for any given value of assets, having more capital serves as a cushion against their falling values. The definition of bank capital is: $$E=A-L$$

Where E represents bank capital. Now, from a textbook I am reading, it says that banks don't like having high amounts of capital, as it reduces their potential profits. I don't understand what that means- doesn't having high amounts of capital mean that the bank is indeed very profitable (maximizing difference between assets and liabilities?)

Answer 1

Two things:

1. Capital not being put to work reveals no profit. This capital could have been invested into something else which may (or may not) have resulted in profit for the bank. Opportunity cost of capital could be rather big. This means that the bank is actually loosing out on potential profits.

2. Capital (in form of equity) does not necessarily mean the company is profitable. Many (often smaller) companies are 100% equity financed - this has no relation to profitability what so ever. Increasing the equity/debt ratio does not say anything about if the company is profitable. It could be because the company has build up equity (yay, this means profits), but it could also be because the company has gotten a capital injection (not affecting profits). It works other ways as well - perhaps a company is very profitable (building equity and not paying dividends), but at the same time they increase their debt, keeping the ratio constant; in this case you cannot see if it is profitable or not. Debt is not the same as “not profitable”. Actually most companies have debt because they may be able to invest the debt at a better rate than their interest rate (eg in machinery to increase production resulting in profits).

Increasing the gap between assets and liabilities is exactly the same as described above. Assets = (Equity + Liabilities).

Answer 2

Let's say the bank holds 100 dollars in deposits.

If they are required to hold 5% in equity (or any other asset class that contributes to the requirement), then they can loan out 95 dollars of the 100 dollars.

If they are required to hold 20% in equity (or any other asset class that contributes to the requirement), then they can only loan out 80 dollars of the 100 dollars.

A relevant concept is "risk-weighted assets", where a highly rated asset (lower risk) contributes more to the requirement than a lowly rated asset (higher risk). If you read up on Basel III in Wikipedia, you can find out more about different types of capital requirements and other stuff that goes with that, in addition to other relevant concepts such as liquidity requirements, etc.

Sometimes the main idea is to prevent a minor run on the bank from turning to catastrophe (maybe a depositor takes their 10 dollars out of the bank, and the bank is left with minus 5 dollars, and cannot meet the ongoing financing requirements of an investment project that they had previously committed to). Other times, it may prevent a small economic downturn from causing havoc in the financial system (maybe several loans are not repaid until later, and the bank has no additional liquidity to finance any new investment projects, causing investment in the economy to collapse). In both cases, the higher capital requirement provides protection against a small problem with one or two banks turning into an economy-wide catastrophe (although it is possible for the requirement to be "too high".)

In other cases, a central bank may use capital requirements to influence overall credit in the financial system, similar to how central banks manage interest rates to influence inflation and thereby other macro variables.