Types of Capital Reserves

Capital reserves maintain the safety of a bank.
Capital reserves maintain the safety of a bank. (Image: bank image by Pefkos from <a href='http://www.fotolia.com'>Fotolia.com</a>)

Capital reserves, or the money a bank has immediately on hand, can take on a few different forms. These are roughly divided into Tier-1 capital and Tier-2 capital. Capital reserves do not necessarily have to be cash. Rather, they just need to be reasonably safe, diversified access to cash or its equivalent in equity.

Tier 1

Tier 1 capital reserves are the book value of a bank's stock plus its retained earnings. The book value is the value of the company when liabilities are subtracted from assets; it is not the market value of the stock. This is because the market value can be different from the book value and is also subject to supply and demand laws on the stock trading floor--it does not reflect the bank's actual value as accurately as the book value does.

Retained earnings are profits that have not been paid out in dividends but have instead been invested back into the bank for development. So, if a bank invests $100 million in one year and makes a 10 percent profit of $10 million, but only pays $7 million in dividends, then its retained earnings are $3 million.

Tier 2

Tier 2 capital is the bank's loan-loss reserves plus its subordinated debt. Loan-loss reserves are money that the bank puts aside in the event of people defaulting on their loans. It is essentially in-house insurance.

Subordinated debt is debt owed by the bank to account holders who have chosen lower-priority accounts. This means that these account holders receive a higher interest rate than standard account holders do, but if the bank should fail then other account holders will receive their funds before the subordinated debt holders do.


Cash is also a legitimate source of capital reserves. However, it is not necessarily in the bank's best interests to have a lot of cash around--cash does not gain interest, and a bank's business model is based around investing cash. However, a large amount of cash can reduce a bank's risk-adjusted capital, which in turn reduces its need for Tier 1 and 2 reserves, which is explained below.


Banks are required by law to have a certain amount of these capital reserves on hand. This is a total of 8 percent of their risk-adjusted assets, of which at least 4 percent must be Tier 1 reserves.

Risk-adjusted assets are the value of a bank's holdings multiplied by a number to compensate for their riskiness. Cash, for example, is solid, so it is multiplied by zero. Unsecured loans, however, are substantially riskier, so they are multiplied by 1. Mortgages, with houses as collateral, are not as risky as the bank has the house to fall back on in the event of default, and therefore are multiplied by 0.5.

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