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As a primer, I want to lay out my limited understanding of the topic:

Common stock:

  • is part of CET1 Capital of a bank
  • used to absorp losses earlier than e.g. preferred stock and other types
  • held by investors of the bank
  • calculated via Total Value of Common Stock = Number of Outstanding Shares * Market Price per Share
  • apparently Total Value of Common Stock is not the same as the Market Cap
  • if a bank only ever issued 1,000 shares at $5 par value and now shares trade at $50 we can assume that the Common Stock is now 10x higher than the paid-in capital

Now, when a bank whose Common Stock is valued at e.g. $100m incurs losses, of e.g. $50m, then it is used to absorb these losses.

It is not clear to me how this works in practice, since the Common Stock is a value created by the markets (demand/supply) and cannot be used directly to cover those losses or liabilities. Or is there a dilution mechanism happening that affects common stock holders but not preferred stock holders?

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This is actually an accounting question; more than economics. Assets = Liabilities + Equity. These terms each have accounting values regardless of what values would be realized in a market. When there is a loss, the accounting value of assets decreases. In your example the loss is 50m dollars and liabilities are unchanged. Algebra says the accounting value of equity will concurrently decrease by 50m dollars. The common stock might be the majority of the equity or it might be all of it if there is no preferred stock. If the equity is all common stock then the accounting value of common stock decreases by 50m dollars. Thus the loss is "absorbed". What stock market investors think about the value of the common stock is a separate matter from the accounting value or "book value" of the common stock.

For a fuller understanding just read any introductory accounting textbook or the Wikipedia entry for "balance sheet".

Wikipedia entry for "balance sheet"

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