Question

In Bank Management, evaluate the function of bank capital. How does changes in bank capital requirements impact regional/national economic growth?

Answer 1

Bank capital is the difference between a bank's assets and liabilities and represents the value of a bank to its investors.

As per Basel III regulatory norms, bank capital is divided into different tiers on the basis of subordination of capital and the ability of the bank to absorb losses. Total regulatory capital is the sum of Tier 1 capital and Tier 2 capital. While, Tier 1 capital has the highest subordination and no maturity, Tier 2 capital consists of unsecured subordinated debt and its stock surplus with original maturity of less than five years minus investments in non-consolidated financial institutions subsidiaries under certain circumstances.

Bank capital plays an important role in bank management. It is the margin by which a bank's assets outweigh its liabilities. Capital secures banks against all uninsured and unsecured risks, which can turn into losses. Therefore, capital's primary functions are to absorb losses and maintain confidence in a bank. Bank capital enables a bank to cover losses like borrower defaults and operating losses from its own funds. Capital also builds credibility of a bank as it provides confidence to bank creditors and depositors that their assets and deposits are safe with the bank.

Another important function played by the capital is financing function. Banks need their own funds to finance fixed assets as deposits are unfit for this purpose. Banks need permanent capital coverage for its fixed assets. Capital also plays restrictive function for banks as there are minimum capital requirements as per various regulations. These requirements place limits on various types of assets and banking transactions, thus preventing the banks from taking too many risks.

Impact on regional/national economic growth: Too much capital requirement for the banks leads to lesser credit availability with the banks. This results in reduction of credit supply as well as credit demand as lending rates tend to be higher with limited funds available for lending. Less credit supply, thus, can slow down the economic growth. However, if the banks are well capitalized, risks are minimized and financial stability is achieved. Financial stability is achieved through reducing the probability of financial distress and minimizing banks' losses given default. Stringent capital requirements increase bank's resilience to future economic downturns. This security against the downturns tends to decrease the risk, decrease the cost of capital and hence support economic growth.