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Brooks Wilson's Economics Blog: Banks and the Importance of Equity

Sunday, November 29, 2009

Banks and the Importance of Equity

Principles of economics textbooks generally omit equity from the balance sheet equation, Assets=Liabilities+Equity, to focus on money creation. Given the financial crisis that became manifest in September 2008 and its continuing aftermath, this post reinserts equity or capital to focus on the risk of insolvency bankers take in lending. The example is provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009. The article often refers to capital, a richer term than equity, the term used in class. When reading the quote, you can replace capital with equity with no loss of understanding. I added Figure 2 to the quote.
Figure 1

Cash $10Equity $5
Loans $90 Deposits $95
Total $100 Total $100

Generally speaking, "capital" is the portion of a bank's assets that does not have to be ultimately repaid to creditors--such as depositors, who are, after all, merely loaning their funds to a bank. To see why capital should offer protection against unexpected losses, consider the following simple example of a bank's balance sheet (Figure 1).
The balance sheet consists of the bank's sources of funds (liabilities) and the uses to which those funds are put (assets). By definition, the two must be equal at all times We can see that our bank has collected $100 of funds: $95 in deposits from retail customers, representing liabilities; and $5 in "capital" which for the moment, we will assume is equity capital: income from issuing shares of common stock in the bank. Such income does not have to be repaid: Shareholders have no legal right to be paid dividends; and common shares have the lowest-priority claim on other assets in case of bankruptcy.

Of the $100 of liabilities (including the $5 in capital), 90 percent is then turned into credit by being loaned out, while 10 percent is held as cash in the bank's vault as cash reserves against potential withdrawals from depositors of a portion of the $95 they have lent to the bank. A bank's loans plus its cash reserves constitute its assets.

Figure 2
Cash $10Equity $3
Loans $88 Deposits $95
Total $98 Total $98
Now imagine that some of those to whom the bank has loaned money unexpectedly default, rendering $2 of loaned assets worthless (Figure 2). The bank has to write off these losses, diminishing the total value of assets to $98. But while the value of the bank's assets has declined by $2, the amount that it owes depositors remains exactly the same ($95). Thus, for assets ($98) to continue to equal liabilities, capital must fall to $3. Suppose, by contrast, that the bank didn't initially have any capital, and that its assets ($90 in loans plus $10 in cash) were financed fully by the collection of $100 in deposits. Any unexpected (and unaccounted for) loss would then render the bank immediately insolvent, as the assets--all that the bank has--would not suffice to pay off all that it owes.

It is only due to the fact that a portion of its financing does not have to be repaid (e.g., the portion obtained from issuing stock) that the bank has the capacity to withstand unexpected losses on the investments that it makes with the funds entrusted to it. That is the primary reason that bank regulators believe it necessary to control the amount of capital that financial institutions hold. On the other hand, holding capital constrains risk-taking (and thus, potentially, profitability); that is the point of the capital regulations. To the extent that bank managers view regulatory capital as a tax imposed on them, they will tend to see capital regulations as obstacles to be gotten around.


  1. Wyconda Erwin1/12/09 2:15 PM

    Our banks put themseleves in these bad predictments because they should not be using the money people put into there banks for trust funds, savings, etc for loans to public. I believe that banks should have money set aside for everything that they can loan to people money loans, business loans and house loans. What we put in the bank should be secured like we expect it to be that's why we are trusting the banks in the first place not loaned out whenever someone is approve for some type loan.They should be in a Finanical crisis with those types of service.

  2. Kristie DeMaria1/12/09 8:56 PM

    As long as the regulations are reasonable I completely agree that there should always be constraints. They not only protect the bank themselves from going out of business, but also the people who have put their trust into that bank. I agree that the bank needs to make loans and that there is a risk involved in that, but I also like the idea that I don't have to worry about losing my money to a gambler who suddenly had a whim on a new investment. Banks still have the flexibility to make money off of loans, they just won't make as much as quick.

  3. Laura Brown1/12/09 10:26 PM

    The bank regulators should control the capital that the banks hold. There should be a requirement for a reserve to withstand possible losses. This would be best for the bank and for the customers. Taking risks is fine, but not if it will cause the bank to become insolvent. There should be a limit on the risks that are taken. I believe that banks can be very profitable through making loans and the huge fees imposed on depositors.

  4. I believe that there should be regulations put on banks. When I put my money in the bank I want to feel like the bank is protecting my money. But I do feel that the risk banks make should be limited and also regulated so that the depositors are not on the lossing end. Banks should be very careful on whom the loan depositors money too. I would hate to be on the lossing end because my bank did not make good decisions of loaning money out. You should take some risk but you should always do it with one eye always on the reserves.

  5. Jared Groppe5/12/09 1:47 PM

    If the regulations on the banks is in a reasonable ammount I think that they should be inforced. I would not put my money in a bank if it is not protected. The banks need to make their money but at the same time they dont need to take all their depositors money. Risks are a part of every choice but I think they should be thought about a couple of times when dealing with money. Fees that are put on people are reasonable but in some cases they are not even close.

  6. Chrissy Tuel5/12/09 4:41 PM

    the banks should not loan out as much money as they are.. they need to save more money and make sure they are managing it better so that problems dont happen as often as they do.

  7. Katrina R.6/12/09 3:46 PM

    I agree with the others. Not saying that all the blame should be placed on the banks but they should look into revamping the loaning process.

  8. libby sullivan9/12/09 11:16 PM

    If a bank were like any other business, then profitability would be its only concern, and the federal government, for the most part, should refrain from restricting its dealings. However, banks cannot simply be in the business of turning a profit, because they are so integral to the entire economic structure of the country at any given time. Of course banks will fight off capital regulations, and they probably should; I like to think they do so knowing full well that there needs to be some regulatory control over their amount of capital. What they are trying to determine is just how much regulation they need to be saddled with. We have come to a point in this country's economy where certain businesses are labeled "too big to fail;" institutions like banks, which virtually dictate in large part the economy's ebb and flow, certainly need some regulation to reign them in.

  9. Brooks,
    Thanks for taking a simple example to explain a complex issue such as this. Could you please explain the following for me:
    - As loans given out by banks result in profits (e.g., through interest/fees less operating costs), these get added to the equity capital and thus, the equity capital account line grows. However, to me this does not feel like a "real thing" that is available to a bank to absorb losses. It feels like "Cash" is the thing that is ultimately available to the bank to absord losses. If that is true, then why worry about equity capital at all?

  10. Anonymous,
    Thank you for the question. I will prepare an full answer on Monday. The short answer is that the ability to use profit as a buffer against losses depends on what the bank does with the profits. If it holds them as reserves, the buffer increases. If it loans the funds to others, it becomes a larger bank with larger reserves, but the reserves as a percentage of assets doesn't change and the bank remains as risky as before.

  11. brittnie white29/4/10 10:56 PM

    i think that the only risks banks should take are calcutated one, because it's people's livelihoods that they're gambling with