Bank capital, and why it is regulated

A bank's capital is the equity of chapter 2 of the Accounting subject — assets minus liabilities. For a bank it does one specific job: it absorbs losses before depositors do.

The arithmetic of the buffer

Work the problem. ₹100 of assets, ₹92 deposits, ₹8 equity. Loans lose 5% — ₹5 of value.

	Before	After
Assets	100	95
Deposits	92	92
Equity	8	3

Equity absorbs the whole loss. Depositors are untouched. The bank is weakened and still solvent.

Now with ₹4 of equity and ₹96 of deposits:

	Before	After
Assets	100	95
Deposits	96	96
Equity	4	−1

The bank is insolvent. Its assets no longer cover what it owes, and the ₹1 shortfall falls on depositors, the deposit insurer, or the public.

Same loss. Different capital. That is the entire argument for regulating it.

Why banks will not choose enough on their own

Equity is the most expensive funding a bank has — chapter 8 of the Corporate finance subject. Deposits are cheap. So return on equity rises as equity falls, and management is usually measured on return on equity.

More importantly: the bank does not bear the full cost of its own failure. Depositors, the insurance scheme and the wider economy do. A cost borne by somebody else does not enter the decision, which is a textbook externality and the standard justification for a rule rather than a judgement.

Hence capital requirements set by the regulator, not by the board.

Risk-weighting, and why it exists

A flat "hold 8% against all assets" would treat a government bond and an unsecured personal loan identically, which would push banks toward the riskiest assets permitted — the same capital charge for far more income.

So capital is held against risk-weighted assets:

$\text{Capital ratio} = \frac{\text{Capital}}{\text{Risk-weighted assets}}$

Safe exposures carry low weights; riskier ones carry high. A bank that doubles its risk must raise more capital, which removes the incentive to maximise risk per rupee of capital.

Two honest limitations:

Weights are judgements. They are set by rule or by a bank's own models, and both have been wrong — notably about assets considered safe until they were not.

Risk weights are backward-looking. An exposure class that has never caused losses carries a low weight until the first time it does.

The tiers

Not all capital absorbs losses equally well, so it is ranked.

Common equity — ordinary shares and retained earnings. Absorbs losses immediately and completely, with no obligation to anyone. The highest quality and the core of every ratio.

Additional tier 1 — instruments that can be written down or converted to equity while the bank is still operating.

Tier 2 — subordinated debt and similar, which absorbs losses only in liquidation.

The distinction matters because a bank can meet a headline ratio with weaker instruments. Common equity tier 1 is the number to look at, and it is disclosed.

The trade-off nobody escapes

More capital means a safer bank and more expensive credit, because the bank is funding itself with costlier equity and will price loans accordingly. Less capital means cheaper credit and a more fragile system.

There is no setting that avoids the trade — only a choice about where to sit on it. That is a policy decision, periodically revised, and revised most sharply after things go wrong.

What to read in a bank's results

• Common equity tier 1 ratio, and its distance above the required minimum
• Leverage ratio — capital against total assets, unweighted. It catches what risk-weighting can miss
• The direction of travel. A ratio falling while the loan book grows means growth is being funded by thinning the buffer
• Whether capital was recently raised, and at what price — a bank issuing equity cheaply is telling you something

The point

Capital is what absorbs losses before depositors do: the same ₹5 loss leaves a well-capitalised bank weakened and an under-capitalised one insolvent. Banks will not hold enough voluntarily, because equity is their costliest funding and they do not bear the full cost of their own failure — so the level is regulated. Ratios are risk-weighted to stop banks maximising risk per rupee of capital, and common equity tier 1 is the figure that matters.