Anna Kozłowska, Expert in the Commercial Banking Department, UKNF

Capital is a key topic in banking. High level of capital is equated with the safety of banks. In case of a loss, capital is a ‘safety buffer’ against the declaration of insolvency: it protects the bank against a situation where the value of the bank’s liabilities will exceed the value of its assets. What matters to capital owners, however, is the actual return, i.e. the amount of profit generated over a year from each unit of the capital invested, subject to the acceptance of a level of risk. The problem is that profit is easily verifiable and objective, while risk is not.

Over years, the value of banks’ capital in relation to the value of their assets decreased steadily, which could be seen in the U.S. Around 1840, that ratio was more than 50%, and 100 years later it fell to only 6%. The decrease in the capital-to-assets ratio could be seen along the development of financial markets and the changes made to increase the safety of the financial system: the development of central banking, deposit guarantee schemes, and the establishment of clearing houses and other organisation that allow secure bilateral transactions. 

Increased security of the system in which banks were operating allowed them to increase leverage. This means that the financing structure became increasingly reliant on debt financing  and less reliant on equity financing. The reason why banks increased leverage is the fact that those two forms of financing involve different costs. Equity financing is considered to be more expensive than debt financing. This can seem unintuitive where a bank doesn’t pay dividends to the owners (e.g. where it fails to achieve a positive financial result) but it pays interest to their creditors. However, the cost of financing has to be seen in the long term and the bank, by definition, has to make profit. One could assume, then, that if the bank makes profit and the level of its equity is appropriate to the risk the bank is exposed to, it will have to be ready to pay even all of its profits. In that case, the cost of capital could be high.

A bank is a specific institution, and its specific nature compared to non-financial entities consists in its ability to raise cheap financing. In particular, it’s the ability to finance its operations with deposits. Access to cheap financing is one of the bank’s main competitive advantages as it affects the net interest income, i.e. the most essential element of the profit and loss statement. A bank deposit has always been considered to be safer than other ways of safekeeping and investing cash. It’s no wonder then that the interest rate on the deposit has been relatively low, especially after various countries introduced deposit guarantee schemes. From the bank’s perspective, capital is a more expensive yet safer form of financing because it can absorb losses. High degree of commitment among the bank’s shareholders also reduces the moral hazard of them transferring the risk, and ultimately the responsibility for the bank, to the financial safety network.

To finance a bank properly is to find a combination of capital and debt that guarantees the required level of profitability, with a specific level of safety. As I mentioned in the beginning, profit is objective, risk is not. Sometimes, especially in the banking sector, risk is spread over time so it can materialise years after the decision. This is why, also due to the lower costs of less safe financing structures, banks had a tendency to operate with excessive leverage. These issues had to be regulated. 

The development of capital requirements can be defined as a search for a middle ground, even though in that case it was more about establishing a minimum level of capital the bank was required to maintain. Reference to capital was made in relation to the bank’s exposures, with an increasing relevance of the idea of identifying an exposure  in a manner which takes into account the related risk. The minimum capital requirement was set on the basis of historically observable relations between the level of capital and the probability of bank failure. The minimum capital requirement, i.e. the ratio of the bank’s capital to its risk-weighted exposure amount, was fixed at 8%. Once that aspect of the banking business was regulated, the regulations underwent multiple revisions, usually following events that revealed their imperfections. Major changes concerned the recognition of exposures and the method of considering the characteristics of the risk taken by the bank, both when it comes to risk measurement methods and various risk types. Another important issue was the need to separate capitals according to their quality – defined as loss absorbing capacity – and to define a minimum capital requirement for each of them. In addition to the common requirements for all banks, there are additional requirements imposed on individual entities in connection with their specific risk which has not been taken into account so far.

Changes were also made to the approach to bank supervision. Supervision focused on individual undertakings, i.e. micro-prudential supervision, was expanded to include macro-prudential supervision. The latter takes into account the environment in which financial institutions operate, both in terms of the impact of the environment on the undertakings and the impact of the undertakings on other market participants, as well as the circumstances in which the institutions operate. The change of the approach was reflected in the capital requirement being increased with capital buffers, i.e. additional capital a bank should have in case of materialisation of a certain material risk at the level of the banking system. Therefore, one of the functions of capital buffers is to accumulate own funds for a rainy day. But this is not their only function. The level of the required capital buffers may be changed from time to time, and an increase or decrease in the capital requirements affects the value of credit provided by the banking system to the economy. This is why another function capital buffers is to reduce the procyclicality of credit by stopping excessive lending or, on the contrary, by releasing capital where the lending activity is threatened due to a decrease in the value of banks’ own funds.

Capital requirements constitute a minimum requirement for the bank’s safety. In fact, banks should operate with a certain level of capital surplus so that in case of any loss the minimum level remains intact, and in order to run their business with ease and have the necessary funds to grow. The level of capital necessary for the safety of the bank has been defined in the regulations as an accepted minimum level. In practice, a bank carrying on its business without any capital surplus is seen by the supervision authority as a risky business.

Capital surplus is necessary to expand the lending activity in the banking sector since it cannot be fully replaced with any other type of financing. To put it simply, 1 billion Polish zlotys translates into the ability to grant loans of up to tens of billions of zlotys, depending on the loan type and risk profile. Banks with no capital surplus will not be providing financing to the economy, since an increase in the value of the loan portfolio would involve an increase in the risk-weighted exposure amount, which – with a fixed value of own funds – would result in the capital ratios falling  below the minimum requirement. A risk-weighted exposure can also increase if the bank does not increase the portfolio value but the risk factors start following a negative pattern. If this is the case, a similar mechanism will be triggered and the bank will no longer meet the capital requirements due to the lack of capital surplus to cover additional risk.

Therefore, capital surplus performs three major functions:

1. Firstly, it absorbs losses that may arise and protects the bank against a breach of the regulatory requirements representing the minimum safety standards.

2. Secondly, it allows to provide financing to the economy by meeting the demand for credit at a certain time.

3. Thirdly, the surplus protects the bank’s capitals in case of an unexpected increase in the level of risk, which is of a very high systemic importance as it protects the system against the need for many banks to strengthen their own funds all at once, and if this is not possible, against a reduction of the banking sector’s assets. Capital surplus improves the resilience of the banking sector to the contagion effect spreading from banks that are unhealthy (i.e. face financial hardship) to entities that are healthy.

It is worth noting that the current level of capital surplus in the banking sector is also the effect of a consistent dividend policy promoted by bank supervisors over the years, recommending banks to keep a part of their profits in order to strengthen their capital.