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Capital represents the loss-absorbing capacity of a bank. I do not understand how shares issued in the past provide any indication of a bank's loss-absorbing capacity. I understand that common equity does not carry with it an obligation to repay, but it is not like banks can "draw down" on the value of its outstanding share in the event it experiences severe losses.

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Equity/stock/capital does absorb losses. Here is a stylized example:

Ann creates a new bank. She puts in \$100 of her own money. This \$100 is her equity/stock/capital.

She borrows another \$900 (debt). (For simplicity we'll assume that all debt/loans have an interest rate of 0%.)

She has a total of \$1,000. She lends all of it to Bob.

A little later, Bob is able to repay only \$925. So, \$75 was lost on this loan.

This \$75 loss is entirely absorbed by the equity/stock/capital, which now falls from \$100 to \$25.

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  • $\begingroup$ But in your example, the capital of the bank would still be $100 after the loss. $\endgroup$ – Ryan da Silva Jun 22 '19 at 13:51
  • $\begingroup$ If the bank takes another loss of $50, the remaining $25 in equity won't help absorb the loss. $\endgroup$ – Ryan da Silva Jun 22 '19 at 13:52
  • $\begingroup$ (I had to post two comments because for some reason, the text kept appearing in the font for equations. Part of the second comment still appeared that way for some reason.) $\endgroup$ – Ryan da Silva Jun 22 '19 at 13:53
  • $\begingroup$ But in your example, the capital of the bank would still be $100 after the loss. No, it falls to \$25, as stated above. If the bank takes another loss of \$50, the remaining \$25 in equity won't help absorb the loss. That's right. The stock/capital/equity will be wiped out. The bank is now underwater (its capital/equity is now −\$25) and has to declare bankruptcy. $\endgroup$ – Kenny LJ Jun 22 '19 at 23:42
  • $\begingroup$ So "common stock" in the definition of bank capital refers to shareholders' equity? $\endgroup$ – Ryan da Silva Jun 23 '19 at 12:34
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It is included at book value (not at market value) since that is the actual cash that was injected. So banks can indeed use this cash

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