1
$\begingroup$

Let's assume that new bank is incorporated and it issued 100 000 shares with nominal value odf $100. Let's also assume that all shares are sold for the same price, so bank now has 10 million dollars.

In equity section on balance sheet, there is now 10 million dollars of ordinary shares. Now let's assume further that 5 years has passed, the bank has spent all 10 million dollars for different purposes (R&D, expansion etc.) and now it doesn't have that money, but there are still 10 million dollar of ordinary share on its balance sheet.

If ordinary shares are vital part of bank's capital, how can they now respresent someting that can save the bank from bankruprtcy it problems occurs, when there is no money??? I'd understand if the bank wasn't allowed to spend that money, but it is used for various purposes.

$\endgroup$
2
$\begingroup$

You are concerned about...

someting that can save the bank from bankruprtcy it problems occurs, when there is no money

This is an accounting question as much as an economics question. What you are asking about is "solvency".

assets minus liabilities equals equity

The bank or any company is solvent by definition if equity is positive and estimated values are realistic. Companies can even be solvent if equity is negative because estimated values are not realistic, for example, if assets are a "conservative" estimate which in this case means assets are underestimated.

You asked about the absence of money. All items in the assets are theoretically convertible to money. They are convertible regardless of the estimate of equity. In practice negative money balances are not necessarily a problem because if equity is large enough the company can obtain a loan. Typically a bank is holding cash because that is the nature of offering "demand" accounts which are the accounts where the depositor can withdraw cash almost immediately.

$\endgroup$
1
$\begingroup$

Equity equals assets minus liabilities. If a bank “spent everything,” assets would be zero, and so equity would have to have been written down to zero. Expenses - including capital depreciation - generate losses that reduce equity unless there are offsetting sources of revenue.

However, this is way too simplistic for discussion of a bank. Banking is a complex, highly regulated businesses, and banks have to pass many different capital and liquidity rules that depend upon the jurisdiction. Lending capacity is not just based on shareholder equity. There is no way that this complexity can be discussed here.

In response to comments, added points.

  • Capital measures are based solely on entries on the right hand side of the balance sheet. Assets are ignored. Bank capital is notionally the amount of losses that can be absorbed before assets are worth less than hard liabilities (deposits, issued bonds, etc.). Common equity can absorb losses with the least issues, and hence has the highest weight.
  • Liquidity needs must be met by selling assets. Bank assets are rated into liquidity classes, and there are rules for relating their size versus liabilities. Bank property has no liquidity value, and so a bank cannot have its entire asset base invested in buildings and operate as a deposit taking bank.
  • Finally, solvency is best understood as “capital adequacy,” and it is not the same thing as “liquidity” - which is the ability to meet cash outflows.
$\endgroup$
5
  • $\begingroup$ Thank you. I don't intend to discuss that complexity, I'm only interested in logic behind ordinary shares being the highest possible form of bank capital. When I say that the bank in our example spent everything, I mean that it spent money from issuing shares on buildings, or some other assets, so the assests are not zero, only there are no more cash from issuing shares. $\endgroup$ – Nikola Feb 22 at 20:36
  • $\begingroup$ If unexpected losses occurs, and bank needs to activate it's capital to be saved from default, how are there ordinary shares of any help, when there money is spent on buying builidings? I understand how retained earning can help, but not shares. Of course, this is silly oversimlification, but hope it will work. $\endgroup$ – Nikola Feb 22 at 20:37
  • $\begingroup$ You are asking about banks, so you need to know how banks work. A bank whose only assets were buildings would be shut down by regulators. They need liquid assets to match against liabilities. The level of equity is not the only thing taken into account by regulators. $\endgroup$ – Brian Romanchuk Feb 22 at 20:56
  • $\begingroup$ Sure, but that doesn't answer my question. Why are ordinary shares regrded as the highest form of capital (they are included in the CET1 capital) , i.e. how they represent any quarantee of bank solvency? I'm not asking about liquidity or other topics. $\endgroup$ – Nikola Feb 22 at 21:32
  • $\begingroup$ Capital is based on entries on the right hand side of the balance sheet. Take a look at a bank balance sheet. The only other items on that side of the balance sheet are quasi-equity (e.g., preferred shares) or liabilities. Do you believe that those are more useful for bank solvency? If you do, which ones? $\endgroup$ – Brian Romanchuk Feb 22 at 22:03
0
$\begingroup$

If a startup raises 10 million dollars, then spends 10 million dollars, and achieves nothing for it, their assets are zero and their liabilities are zero, so their equity is zero. The shares aren't worth 10 million dollars any more. They're worth zero.

$\endgroup$
0
$\begingroup$

I revised this answer to more directly address the question posed. Apply the Charts of Account shown in the hypothetical bank balance sheet of this 4 page paper:

https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2012/pdf/eb_12-03.pdf

Then your new bank holds 10M cash when it issues 10M paid-in equity. The bank uses the initial cash to pay expenses and acquire assets but as part of the bank business model it also issues deposits and other liabilities to develop more sources of cash.

Assume after five years that total retained earnings equal 5M and the ratio of assets to equity is 10 to 1. Then equity is 15M, assets 150M, and deposits 150M - 15M = 135M.

By law and custom the equity capital absorbs the first loss on the loan portfolio. So if there is a 15M loss in the loan portfolio then it would wipe out all of the 15M equity. The owners of these equity claims could no longer hope to earn dividends or to convert their equity claims back into deposits by selling the equity to some other investor(s). This equity is "capital at risk".

The unsecured or uninsured depositors (and other creditors) take the remainder of the loss if the bank is resolved during insolvency. So in this scenario if there were a 25M loss on assets then 15M is allocated to equity owners and another 10M is allocated to the unsecured and/or uninsured creditors. These liabilities are also "capital at risk".

$\endgroup$
1
  • $\begingroup$ Thank you! This is very neat and down to the ground explanation! $\endgroup$ – Nikola Feb 23 at 19:55

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.