Bank Capital [CapiPedia]

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======Bank Capital======
Bank Capital is the financial cushion that protects a bank, its depositors, and the wider economy from unexpected losses. Think of it like the [[Equity]] in your home; it’s the difference between what the bank owns ([[Assets]], like loans and securities) and what it owes ([[Liabilities]], like customer deposits). This capital, primarily composed of `[[Shareholder Equity]]` and `[[Retained Earnings]]`, serves as a first line of defense. If a bank’s loans start to go bad and the value of its assets falls, the capital absorbs these losses, ensuring the bank can still honor its commitments to depositors. Unlike a typical manufacturing company, banks operate with immense `[[Leverage]]`, borrowing vast sums to lend out. This makes a strong capital base not just a matter of good housekeeping but a fundamental prerequisite for survival, a lesson painfully learned during the `[[Financial Crisis of 2008]]` when many undercapitalized institutions collapsed.
===== Why Bank Capital is the Bedrock of Banking =====
A bank’s business model is elegantly simple at its core: it takes in money (deposits) and lends it out at a higher interest rate, earning the difference. The danger lies in the assets—the loans. If borrowers default, the value of those assets plummets. Without a sufficient capital buffer, this loss would immediately eat into the money owed to depositors, causing a panic and a potential bank run.
Bank capital is the wall that stands between a bank’s operational losses and its depositors' funds. It provides the institution with the ability to withstand financial stress and continue operating. For a value investor, analyzing a bank is less about its potential for spectacular growth and more about its resilience and durability. A bank with a thick capital cushion is a fortress; one with a thin buffer is a house of cards, ready to topple in the first strong wind.
===== Measuring the Cushion: Key Capital Ratios =====
Simply looking at the absolute dollar amount of capital isn't enough. Regulators and savvy investors measure capital //relative// to the risks a bank is taking. This is where capital ratios come in, which are governed by a global regulatory framework known as the `[[Basel Accords]]`.
==== Tier 1 vs. Tier 2 Capital ====
Regulators have established a hierarchy of capital to measure its quality and loss-absorbing capacity.
  * **[[Tier 1 Capital]]**: This is the highest-quality, core capital. It’s the money that can absorb losses without forcing the bank to stop operating. Its most important component is `[[Common Equity Tier 1 (CET1)]]`, which includes common stock and retained earnings—the purest form of a financial cushion.
  * **[[Tier 2 Capital]]**: This is supplementary capital. It includes things like subordinated debt and is designed to absorb losses if a bank fails and goes into liquidation. While useful, it doesn't help keep a struggling bank in business. For this reason, investors focus far more on Tier 1 capital.
==== The All-Important Ratios ====
To create a true like-for-like comparison, a bank's capital is measured against its `[[Risk-Weighted Assets (RWA)]]`. This clever concept assigns a risk level to each of the bank's assets. A government bond might have a 0% risk weighting, while an unsecured personal loan would have a much higher one.
The most critical ratios you'll encounter are:
  - **CET1 Ratio**: CET1 Capital / RWA. This is the gold standard for measuring a bank's financial strength.
  - **Tier 1 Capital Ratio**: Tier 1 Capital / RWA.
  - **Total [[Capital Adequacy Ratio (CAR)]]**: (Tier 1 + Tier 2 Capital) / RWA.
Under the latest `[[Basel III]]` rules, banks must meet minimum requirements for these ratios. However, a prudent investor looks for much more than the bare minimum.
===== A Value Investor's Checklist for Bank Capital =====
When you analyze a bank, think like a risk manager. Your primary goal is the preservation of your capital, and that means investing in only the safest, most durable institutions.
  * **Look Beyond the Minimums**: A bank that is just scraping by its regulatory minimums is a fragile institution. Great banks, like the ones favored by investors like Warren Buffett, maintain capital ratios far in excess of what is legally required. This is their //Margin of Safety//.
  * **Focus on Quality (CET1)**: Don't be fooled by a high Total Capital Ratio that is propped up by lower-quality Tier 2 capital. The CET1 ratio is the true measure of a bank's ability to weather a storm. A high and rising CET1 ratio is a sign of a conservative and well-managed bank.
  * **Understand the Safety vs. Profitability Trade-Off**: High leverage (and thus, lower capital) can juice a bank’s `[[Return on Equity (ROE)]]`. Some management teams are tempted to run with thin capital to produce impressive short-term profit metrics. A value investor is wary of this, preferring the long-term compounding that comes from a secure, over-capitalized institution, even if its ROE is slightly less spectacular.
  * **Check the `[[Stress Test]]` Results**: In the U.S. and Europe, major banks undergo annual stress tests. Regulators simulate a severe economic crisis and see if the bank’s capital is strong enough to survive. The results of these tests are publicly available and provide an invaluable, forward-looking assessment of a bank’s resilience.