Externally Imposed Capital Requirements

Capital requirements on banks are laws that force them to have certain amounts of capital on hand. Because a bank's bankruptcy has more extensive repercussions than the bankruptcies of other industries, the only US industry subject externally imposed capital requirements is the banking industry.

If, for example, an auto manufacturer becomes insolvent, its suppliers and workers are left with money owed. Traumatic as this is, the banking industry also handles its customers' money, which means that a bank's bankruptcy not only costs the bank, its employees and its suppliers, but also its customers.

William F Hummel, author of the website "Money: What It Is, How It Works," explains capital requirements as the amount of capital a bank is legally required to maintain This is measured as a proportion of its total holdings, adjusted for the riskiness of those holdings. The total amount of capital on hand needs to be 8 percent of the risk-adjusted asset value, with at least 4 percent coming from Tier 1 sources and the remainder coming from Tier 2 sources.

Capital requirements are determined as a proportion of the risk-adjusted value of the bank's assets, not as a proportion of its total value. Risk-adjusted value is calculated in the following manner, with an exemplar in parentheses:

Multiply the total value of cash and government securities on hand by 0 ($8m x 0 = 0). Multiply the total value of loans owed from other banks by 0.2 ($20m x 0.2 = $4m) Multiply the total value of loans owed by mortgage holders by 0.5 ($20m x 0.5 = $10m) Multiply the total value of loans ordinary loans and loans secured by letters of credit by 1 ($50m x 1 = $50m)

Add your figures to get a risk-adjusted asset total. (0+$4m + $10m + $50m = $64m)

Tier 1 capital needs to be at least 4 percent of the risk-adjusted asset total. In this case, that figure is $2.56 million. This capital must be made up of one or a combination of the book value of the stock and/or the bank's retained earnings, which are earnings that the bank has chosen not to pay off as dividends but rather to put back into itself for business development. Therefore, if our theoretical bank's stock's book value is $3.2 million, it does not need to have any retained earnings. While legal, this would probably not be wise, as a drop in stock value would render trading illegal.

The remainder of the capital requirements can be made up of Tier 2 sources. These are calculated by adding the loan-loss reserves, which are reserves a bank has put aside to protect itself from debtors defaulting, to the value of its subordinate loans, which is higher-risk money people have deposited in the bank with the understanding that in the event of default others will be paid back first.

In the example above, the Tier 1 value was $3.2 million, which is 5 percent of the risk-adjusted asset value of $64 million. This means that the Tier 2 capital value needs to be only 3 percent of the risk-adjusted capital value to make a total of 8 percent. This is $1.92 million.