Bank Capital and Liquidity

2/5/2019 Bank Capital and Liquidity - Risk.
net
Chapter first published in:
The Handbook of ALM in Banking

Edited by Andreas Bohn and Marije Elkenbracht-Huizing
First published:
12 JAN 2018
ISBN: 9781782723455
Bank Capital and Liquidity

Marc Farag, Damian Harland, Dan Nixon
Bank capital, and a bank’s liquidity position, are concepts that are central to
understanding what banks do, the risks they take and how best those risks should be
mitigated both by banks themselves and by prudential regulators. As the 2007–9
financial crisis powerfully demonstrated, the instability that can result from banks
having insufficient financial resources – capital or liquidity – can acutely undermine the
vital economic functions they perform.
This chapter is split into three sections. The first section introduces the traditional
business model for banks of taking deposits and making loans. The second section
explains the key concepts necessary to understand bank capital and liquidity. This is
intended as a primer on these topics: while some references are made to the 2007–9
financial crisis, the aim is to provide a general framework for thinking about bank
capital and liquidity. For example, the chapter describes how it can be misleading to
think of capital as “held” or “set aside” by banks; capital is not an asset. Rather, it is a
form of funding: one that can absorb losses that could otherwise threaten a bank’s
solvency. Meanwhile, liquidity problems arise due to interactions between funding and
the asset side of the balance sheet, when a bank does not hold sufficient cash (or
assets that can easily be converted into cash) to repay depositors and other creditors.
Appendix A explains some of the accounting principles germane to understanding bank
capital.
The final section gives an overview of capital and liquidity regulation. It is the role of
bank prudential regulation to ensure the safety and soundness of banks, for example,
by ensuring that they have sufficient capital and liquidity resources to avoid a disruption
to the critical services that banks provide to the economy. In April 2013, the Bank of
England (“the Bank”), through the Prudential Regulation Authority (PRA), assumed
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2/5/2019 Bank Capital and Liquidity - Risk.net
responsibility for the safety and soundness of individual firms, which involves the
microprudential regulation of banks’ capital and liquidity positions.1 At the same time,
the Financial Policy Committee (FPC) within the Bank was given legal powers and
responsibilities2 to identify and take actions to reduce risks to the financial system as a
whole (macroprudential regulation) including by recommending changes in bank capital
or liquidity requirements, or directing such changes in respect of certain capital
requirements. In 2013 the FPC made recommendations on capital that the PRA have
taken steps to implement.3
THE TRADITIONAL BANKING BUSINESS MODEL

Understanding why capital and liquidity are important requires an overview of what
banks do. This section sets out the traditional banking business model, using a
simplified bank balance sheet as an organising framework and highlighting some of the
risks inherent in a bank’s business.
Banks play a number of crucial roles in the functioning of the economy. First, they
provide payments services to households and companies, allowing them to settle
transactions. Second, they provide credit to the real economy, for example, by
providing mortgages to households and loans to companies. Third, banks help
households and businesses to manage the various risks they face in different states of
the world. This includes offering depositors access to their current accounts “on
demand”, as well as providing derivatives transactions or other financial insurance
services for their broader customer base.4
The focus for this chapter is the second function: providing credit to the real economy.
Borrowers frequently need sizeable longer-term loans to fund investments, but those
with surplus funds may individually have smaller amounts and many want swifter
access to some or all of their money. By accepting deposits from many customers,
banks are able to funnel savers’ funds to customers that wish to borrow. So, in effect,
banks turn many small deposits with a short-term maturity into fewer longer-term loans.
This “maturity transformation” is therefore an inherent part of a bank’s business model.
Banks profit from this activity by charging a higher interest rate on their loans than the
rate they pay out on the deposits and other sources of funding used to fund those
loans. In addition, they may charge fees for arranging the loan.5
Introducing a bank’s balance sheet
A useful way to understand what banks do, how they make profits and the risks they
take is to consider a stylised balance sheet, as shown in Figure 1.1. A bank’s balance
sheet provides a snapshot at a given point in time of the bank’s financial position. It
shows a bank’s “sources of funds” on one side (liabilities and capital) and its “use of
funds” (that is, its assets) on the other side. As an accounting rule, total liabilities plus
capital must equal total assets.6
Like non-financial companies, banks need to fund their activities and do so by a

mixture of borrowed funds (“liabilities”) and their own funds (“capital”). Liabilities (what
banks owe to others) include retail deposits from households and firms, such as
current or savings accounts. Banks may also rely on wholesale funding: borrowing
funds from institutional investors such as pension funds, typically by issuing bonds. In
addition, they borrow from other banks in the wholesale markets, increasing their
interconnectedness in the process. A bank’s capital represents its own funds. It
includes common shares (also known as common equity) and retained earnings.
Capital is discussed in more detail in the following section.
Banks’ assets include all financial, physical and intangible assets that banks currently
hold or are due to be paid at some agreed point in the future. They include loans to the
real economy, such as mortgages and personal loans to households, and business
loans. They also include lending in the wholesale markets, including to other banks.
Lending can be secured (where a bank takes collateral that can be sold in the event
that the borrower is unable to repay) or unsecured (where no such collateral is taken).
As well as loans, banks hold a number of other types of assets, including: liquid assets
such as cash, central bank reserves or government bonds;7 the bank’s buildings and
other physical infrastructure; and “intangible” assets, such as the value of a brand.
Finally, a bank may also have exposures that are considered to be “off balance sheet”,
such as commitments to lend or notional amounts of derivative contracts.
Credit risk, liquidity risk and banking crises

In transforming savers’ deposits into loans for those that wish to borrow, the traditional
banking business model entails the bank taking on credit risk and liquidity risk.8 Credit
risk is the risk of a borrower being unable to repay what they owe to a bank. This
causes the bank to make a loss. This is reflected in a reduction in the size of the bank’s
assets shown on its balance sheet: the loan is wiped out, and an equivalent reduction
must also be made to the other side of the balance sheet, by a reduction in the bank’s
capital. If a bank’s capital is entirely depleted by such losses, then the bank becomes
“balance-sheet insolvent”, that is, its liabilities exceed its assets (Figure 1.2).
Liquidity risk takes a number of forms. Primarily for a bank, it is the risk that a large
number of depositors and investors may withdraw their savings (that is, the bank’s
funding) at once, leaving the bank short of funds. Such situations can force banks to
sell off assets – most likely at an unfavourably low price – when they would not
otherwise choose to. If a bank defaults, being unable to repay to depositors and other
creditors what they are owed as these debts fall due, it is “cashflow insolvent”. This is
illustrated in Figure 1.3. A bank “run”, where many depositors seek to withdraw funds
from the bank, is an extreme example of liquidity risk.
The failure of a bank can be a source of financial instability because of the disruption to
critical economic services. Moreover, the failure of one bank can have spillover effects
if it causes depositors and investors to assume that other banks will fail as well. This
could be because other banks are considered to hold similar portfolios of loans, which
might also fail to be repaid, or because they might have lent to the bank that has failed.
These risks and others must be managed appropriately throughout the business cycle.
The following section considers in more detail how bank capital can mitigate the risk of
an insolvency crisis materialising and how a bank’s mix of funding and buffer of liquid
assets can help it to prevent or withstand liquidity stresses.
CAPITAL AND LIQUIDITY
The difference between capital and liquidity: an

overview
As outlined in the previous section, a bank’s capital base and its holdings of liquid
assets are both important in helping a bank to withstand certain types of shocks. But,
just as their natures as financial resources differ, so does the nature of the shocks they
mitigate against. Capital appears alongside liabilities as a source of funding; but, while
capital can absorb losses, this does not mean that those funds are locked away for a
rainy day. Liquid assets (such as cash, central bank reserves or government bonds)
appear on the other side of the balance sheet as a use of funding, and a bank holds a
buffer of liquid assets to mitigate against the risk of liquidity crises caused when other
sources of funding dry up.
Table 1.1 Key properties of different types of bank funding and assets
Sources of funding (liabilities and capital)

If a bank becomes insolvent, “senior” liabilities are repaid before “junior” ones. Common equity is the most junior and is the
Seniority:
first to absorb any losses.
This refers to the date at which funding can be contractually withdrawn. Some funds can be withdrawn at any time by the
Maturity:
borrower (such as current accounts). Others have a fixed term (a two-year bond, say) or are permanent (common shares).
The cost is the expected rate of interest that a bank pays on its liabilities or capital. Typically, the more credit risk or liquidity
Cost:
risk a bank takes, the higher the yield it needs to offer in order to attract investors.
Use of funding (assets)
This is a measure of the ease with which an asset can be converted into cash. Central bank reserves and “safe” securities
Liquidity: like government bonds are considered liquid, while loans to households and firms, or a bank’s buildings, are relatively illiquid
assets.
This is the risk that a borrower will fail to pay what they owe on the due dates. Government bonds (with high credit ratings)
Credit
are usually considered “low-risk” assets. Loans carry credit risk, the amount varying for different types of borrower and loan
risk:
product.
This is the return (interest and fees) banks earn on their assets. For loans, it is reflected in the interest rate they charge, plus
Yield:
any fees. Typically, lending offers banks a higher yield (but also more risk) than they can get by holding a safer asset.
Importantly, both capital and liquidity provisioning and risk mitigation require the
consideration of the details of both the “source of funds” side and the “use of funds”
side of the balance sheet. It is useful to consider how the characteristics of various
types of typical bank assets and liabilities differ. Some of these characteristics are
summarised in Table 1.1.
For instance, if a bank holds more risky assets (such as unsecured loans to
households and firms) it is likely to need to hold more capital, to mitigate against the
risk of losses in the event that such loans default. And if a bank relies on a high
proportion of unstable or “flighty” sources of funding for its activities, such as short-term
wholesale funding, then, to avoid the risk of a liquidity crisis, it will need to hold more
liquid assets.
The following subsections explain the concepts of capital and liquidity in more detail.
While they are considered separately here, in practice, there is often likely to be
considerable interplay between risks to a bank’s capital and liquidity positions. Doubts
surrounding a bank’s capital adequacy, for example, can cause creditors to withdraw
their deposits. Meanwhile, actions that a bank takes to remain liquid, such as “fire
sales” or paying more than it would normally expect for additional funds, can, in turn,
reduce profits or cause losses that undermine its capital position. Some of the ways in
which changes in a bank’s capital position could affect its liquidity position, and vice
versa, are discussed at the end of the chapter.
Capital
As noted above, banks can make use of a number of different funding sources when
financing their business activities.
Capital can be considered as a bank’s “own funds”, rather than borrowed money such
as deposits. A bank’s own funds are items such as its ordinary share capital and
retained earnings, in other words, not money lent to the bank that has to be repaid.
Taken together, these own funds are equivalent to the difference between the values of
total assets and total liabilities.
While it is common usage to refer to banks “holding” capital, this can be misleading:
unlike items such as loans or government bonds that banks may actually hold on the
asset side of their balance sheet, capital is simply an alternative source of funding,
albeit one with particular characteristics.
The key characteristic of capital is that it represents a bank’s ability to absorb losses
while it remains a “going concern”. Many of a bank’s activities are funded from
customer deposits and other forms of borrowing by the bank that it must repay in full. If
a bank funds itself purely from such borrowing, that is, with no capital, then if it incurred
a loss in any period, it would not be able to repay those from whom it had borrowed. It
would be balance-sheet insolvent: its liabilities would be greater than its assets. But if a
bank with capital makes a loss, it simply suffers a reduction in its capital base. It can
remain balance-sheet solvent.
There are two other important characteristics of capital. First, unlike a bank’s liabilities,
it is perpetual: as long as it continues in business, the bank is not obligated to repay
the original investment to capital investors. They would only be paid any residue in the
event that the bank is wound up, and all creditors had been repaid. And second,
typically, distributions to capital investors (dividends to shareholders, for instance) are
not obligatory and usually vary over time, depending on the bank’s profitability. The flip
side of these characteristics is that shareholders can generally expect to receive a
higher return in the long run relative to debt investors.
Expected and unexpected losses

Banks’ lending activities always involve some risk of incurring losses. Losses vary from
one period to another; and they vary depending on the type of borrower and type of
loan product. For example, an unsecured business loan to a company in an industry
with highly uncertain future earnings is riskier than a secured loan to a company whose
future revenue streams are more predictable.
While it is not possible to forecast accurately the losses a bank will incur in any given
period, banks can estimate the average level of credit losses that they expect to
materialise over a longer time horizon. These are known as expected losses.
Banks can take account of their expected losses when they manage their loan books.
Expected losses are effectively part of the cost of doing business; as such, they should
be taken into account in the interest rate that the bank sets for a particular loan.
Suppose, for example, a bank lends £1 to 100 individuals and it expects that 5% of its
loans will default, and it will receive no money back. For simplicity, it is assumed that
the bank has no operating costs and is not paying any interest itself on the £100 of
funds that it is lending out. In this scenario, if the bank charges no interest on the loans,
then it would expect to receive £95 back from the borrowers. In order to (expect to)
receive the full £100 back it would need to charge interest on each individual’s loan.
The required interest rate works out to be just fractionally more than the proportion of
borrowers expected to default. In this example, then, the bank would need to charge
just above 5% on each of the £1 loans in order to (expect to) break even, taking
account of expected losses.9 Of course, banks are not able to predict future events
perfectly. Actual, realised losses will typically turn out higher or lower than losses that
had been expected. Historical losses may prove poor predictors of future losses for a
number of reasons. The magnitude and frequency of adverse shocks to the economy
and financial system, and the riskiness of certain types of borrowers and loans, may
change over time. For loans where borrowers have pledged collateral, banks may
recover less than they had expected to in the event of default. In the case of
mortgages, for example, this would occur if the value of the property falls between the
time the loan was made and when the borrower defaults. Or banks may underestimate
the likelihood that many borrowers default at the same time. When the economy is
unexpectedly hit by a large, adverse shock, such as that experienced during the 2007–
9 financial crisis, all of these factors may be at play.
Banks therefore need to take account of the risk that they incur unexpected losses over
and above expected losses. It is these unexpected credit losses (the amount by which
the realised loss exceeds the expected loss) that banks require a buffer of capital to
absorb.
While expected losses can, arguably, be estimated when sufficient past data is
available, unexpected losses, in contrast, are by their nature inherently hard to predict.
They would include losses on banks’ loan books associated with large, adverse shocks
to the economy or financial system. Figure 1.4 gives a stylised example of how actual,
realised losses can be split into expected and unexpected components. Part (b) shows
that for a given period, while the expected loss rate is the expected outcome, in reality
losses may be higher or lower than that.
Accounting for losses on the balance sheet

Usually, there is a period between when a borrower has defaulted and when the bank
“writes off” the bad debt. When losses on loans are incurred, banks set aside
impairment provisions. Provisions appear on the balance sheet as a reduction in
assets (in this case, loans) and a corresponding reduction in capital. Impairment
provisions are based on losses identified as having been incurred by the end of the
relevant period, but not yet written off. Appendix A discusses developments in the
accounting treatment of provisions in more detail. It also explains other accounting
principles relevant to understanding bank capital, such as how retained earnings feed
into the capital base and the different ways of valuing financial assets.
The leverage ratio

A useful indicator of the size of a bank’s balance sheet – and hence potential future
losses that a bank is exposed to – relative to its “own funds” (capital) is the leverage
ratio. In the context of regulatory requirements, it is usually expressed inversely, as the
ratio of capital to total assets.10 It reflects an aspect of the riskiness of a bank since
capital absorbs any losses on the bank’s assets: so, high leverage (that is, a low ratio
of capital to total assets) is riskier, all else being equal, as a bank has less capital to
absorb losses per unit of asset. This could increase the risk of the bank not being able
to repay its liabilities. Different definitions of leverage can also include a bank’s off-
balance-sheet exposures. These include items such as derivatives, security lending
and commitments. By capturing these items, the leverage ratio provides a relatively
comprehensive overview of a bank’s capital relative to its total exposures. Other
metrics for gauging the capital adequacy of a bank, such as the risk-based capital ratio,
are discussed in the section on capital regulation.
Liquidity
The concept of liquidity is also intrinsically linked to both sides of a bank’s balance
sheet. It relates to the mix of assets a bank holds and the various sources of funding
for the bank, in particular, the liabilities which must in due course be repaid. It is useful
to distinguish between two types of liquidity risk faced by banks (see, for example,
Brunnermeier and Pedersen 2008).
Funding liquidity risk: this is the risk that a bank does not have sufficient cash or
collateral to make payments to its counterparties and customers as they fall due (or
can only do so by liquidating assets at excessive cost). In this case the bank has
defaulted. This is sometimes referred to as the bank having become “cashflow
insolvent”.
Market liquidity risk: this is the risk that an asset cannot be sold in the market
quickly, or, if its sale is executed very rapidly, that this can only be achieved at a
heavily discounted price. It is primarily a function of the market for an asset, and not
the circumstances of an individual bank. Market liquidity risk can soon result in the
bank facing a funding liquidity crisis. Alternatively, with a fire sale, it may result in the
bank suffering losses which deplete its capital.
Banks can mitigate these liquidity risks in two ways. First, they can seek to attract
stable sources of funding that are less likely to “run” in the event of stressed market
conditions. Second, banks can hold a buffer of highly liquid assets or cash that can be
drawn down when their liabilities fall due. This buffer is particularly important if a bank
is unable to roll over (renew) its existing sources of funding or if other assets are not
easy to liquidate. This buffer mitigates both types of liquidity risk.
Liquidity crises: “runs” on banks

A bank “run” is an acute crystallisation of funding liquidity risk and occurs when a
significant number of depositors seek to withdraw funding at the same time. The
reason this can happen relates to the “maturity transformation” aspect inherent to
traditional banking: short-term liabilities, including deposits, are used to fund long-term
loans.
One trigger for a run on a bank is whether creditors have confidence that the bank is
“balance-sheet insolvent”, that is, whether it has sufficient capital to absorb losses and
to repay its deposits. In this case a depositor who withdraws their funds early will
receive all of their money back immediately, while one who waits may only receive
compensation up to the £85,000 limit from the Financial Services Compensation
Scheme (FSCS) within a target of seven days.11
Liquidity risk can also arise for other reasons. For instance, “contingent risk” arises
from scenarios such as an increase in the number of customers drawing down pre-
agreed credit lines. In this scenario the bank’s liquid assets are used to meet the
contingent commitments to such customers, so that the assets are transformed into
loans.
Mitigant (i): stable funding profiles

A bank can adopt a stable funding profile to mitigate against funding liquidity risk and
minimise the chances of a bank run happening. Runs are caused by depositors
reacting to a fear of losing their money and enforcing their contractual right to withdraw
their funding. Stable funding is therefore typically
diversified across a range of sources,
sourced from investors or depositors who are less likely to withdraw funds in the event
that a bank makes losses,12 and
sourced via instruments that contractually lock in investors’ savings for a long period
of time.
Banks typically assess the stability of their depositors in three stages: they start with
the borrower’s contractual rights, then they assess their behaviour in normal times, and
finally they predict behaviour in a stressed market scenario.
In the case of retail deposits (such as households’ current accounts), while account
holders may have the contractual right to withdraw on demand, these deposits in
normal times may be very stable, not least because retail depositors have the
protection of a deposit guarantee up to £85,00013 and are thus less incentivised to
monitor the credit quality of the bank. Retail depositors generally withdraw deposits as
and when needed, to pay for the goods and services they want to buy. In a stressed
environment, such depositors may seek to withdraw their funds to a greater extent due
to wider uncertainties. For wholesale unsecured investors, short-term deposits typically
have a fixed maturity date. In normal times they would be likely to roll over funding as it
matures, but in a stressed market these informed investors are very sensitive to the
creditworthiness of the deposit-taking bank and may withdraw substantial volumes of
funding.
One measure of a bank’s funding profile is its loan-to-deposit ratio. A bank with a high
ratio of loans (which tend to be long term and relatively illiquid) to retail deposits could
imply a vulnerable funding profile. Although widely used, this is an imperfect
assessment of a bank’s structural funding profile since certain forms of stable funding,
such as long-term debt funding, are excluded.
The 2007–9 financial crisis exposed a number of cases of liquidity and funding
problems that resulted from a false assessment of funding stability, especially short-
term wholesale funding. And while a maturity mismatch is inherent in the “borrow short
term, lend long term” banking business model which plays a vital role in providing
credit to the economy, the resulting funding liquidity risk can lead to the failure of a
bank. Liquidity regulation, as described later in this chapter, seeks to incentivise the
use of stable funding structures and discourage maturity transformation using unstable
funding sources.
Mitigant (ii): buffer of liquid assets

The second line of defence against funding liquidity shocks is for banks to hold a buffer
of liquid assets. A bank’s liquidity resources are cash or assets that the bank can
convert into cash in a timely manner and at little cost. They help a bank manage its
liquidity risk in two ways. First, they provide a source of liquidity to ensure the bank can
meet payments that come due in a stress. Second, their very existence can provide
reassurance that a bank will be able to continue to meet its obligations. This reduces
incentives for its depositors to “run”.
A bank can convert its buffer into cash either by selling the assets or by pledging them
to secure borrowing. In normal times this may be simple to execute, but banks face
market liquidity risk so that, in order to be a reliable source of funds across a range of
possible market conditions, the buffer should comprise assets that have the best
chance of remaining liquid in stressed times. The Basel Committee on Banking
Supervision (BCBS) outlines certain characteristics of assets and markets that
maximise this chance (Basel Committee on Banking Supervision 2013).
The most liquid assets in the financial system are on-demand deposits at the central
bank, also called reserves. They are essentially credit-risk-free and can be used to
make payments to counterparties directly. However, they are also low yielding and as
such have a significant opportunity cost (that is, representing the “lost” opportunity for
income from other, more profitable uses of funds).
Other securities that trade in active and sizeable markets and exhibit low price volatility
can also be liquid during a stress, for instance, government bonds and corporate bonds
issued by non-financial companies. While these securities may remain liquid, selling
such assets during stressed market conditions could entail significant discounts and
losses.14
A key role of the central bank is to provide liquidity insurance to the banking system to
help banks cover unexpected or contingent liquidity shocks. Since the crisis, the Bank
of England has significantly expanded its Sterling Monetary Framework facilities to
ensure that it offers effective liquidity insurance to the banks. At the time of writing the
Bank is currently considering further suggestions to improve the efficacy of its liquidity
insurance facilities: see the report by Winters (2012).15
CAPITAL AND LIQUIDITY REGULATION
The previous section explained capital and liquidity and why they are needed to help
mitigate the risks that banks take. Building on that, this section provides an overview of
the key concepts related to capital and liquidity regulation.
The PRA requires banks to have adequate financial resources as a condition of

authorisation. Regulation is designed to help correct market failures and the costs to
society that these impose.16 Specifically, the critical services that banks provide mean
that public authorities will provide support in a crisis, for example by insuring deposits,
acting as a lender of last resort, or bailing out banks directly. Expectations of public
support in stressed conditions lead to the problem of “moral hazard” whereby banks
take on excessive risk, funding their activities with lower levels of capital or liquidity
than they would otherwise. Moreover, these expectations mean that depositors and
investors do not discipline banks sufficiently, which pushes down on banks’ cost of
funding and exacerbates the incentives for banks to take on more risk.
This is a problem because it gives rise to a “negative externality”: excessive risk-taking

by banks leads to costs to other parties (the taxpayers that provide for public support).
Microprudential regulation seeks to address this negative externality by ensuring that
banks manage their activities with sufficient levels of capital and liquidity to reflect the
risks that they take.17 The intention is not to stop banks taking risk – this is an essential
part of the economic function that they play – but rather, to ensure that these risks are
appropriately accounted for. Consistent with this, the PRA does not operate a “zero-
failure” regime: inevitably there will be cases where banks, like other types of firm, fail.
In these cases, it is the regulator’s responsibility to seek to ensure that a bank that fails
does so in a way that avoids significant disruption to the supply of critical financial
services (Bailey et al 2012).
In addition to microprudential regulation, which is focused on the specific risks to

individual banks, there is also a need to consider the risks stemming from the system
as a whole. For example, a buildup in leverage across the system, or an increase in
the magnitude of maturity transformation, may increase negative externalities and the
riskiness of banks.18 Examples of such externalities are contagion risks arising through
the interconnectedness and common exposures of banks. Building on the
microprudential regulatory framework, macroprudential regulation seeks to address
such risks (Tucker et al 2013; Murphy and Senior 2013).
The following sections provide a high-level overview of the frameworks for capital and
liquidity regulation and illustrate how they relate to the risks banks take. Relatively
more detail is given on capital regulation since more agreements have been reached
regarding the international framework than is the case for liquidity regulation. Typically,
regulation takes the form of a requirement specified as a ratio comparing the bank’s
financial resources against certain aspects of the bank’s activities, so as to ensure the
bank holds what it might conceivably need to stay liquid and solvent. For example, the
ratio could be how much capital banks have relative to their total assets (the leverage
ratio outlined above) or the amount of liquid assets that they hold relative to expected
outflows as funding expires (a liquidity ratio).
Capital regulation
This section sets out, at a high level, the regulatory framework for capital that is applied
to banks in the UK. The framework is embodied in EU law based on internationally
agreed “Basel” standards. The EU law had been updated close to the time of writing,
reflecting the Basel III standards.
As mentioned above, certain key ratios are useful in thinking about how much capital a
bank needs. The previous section defined the leverage ratio as a bank’s capital divided
by its total assets. But of course some assets are riskier than others, and each asset
class can be assigned a risk weight according to how risky it is judged to be. These
weights are then applied to the bank’s assets, resulting in risk-weighted assets
(RWAs). This allows banks, investors and regulators to consider the risk-weighted
capital ratio, which is a bank’s capital as a share of its RWAs. Another way of thinking
about this approach is to consider a different capital requirement for each asset,
depending on its risk category.
Banks can alter their ratios by either adjusting the numerator (their capital resources)
or the denominator (the measure of risk). For example, they can improve their capital
ratio either by increasing the amount of capital they are funded with, or reducing the
riskiness or amount of their assets (Tucker 2013). It is common to refer to shortfalls in
required ratios in terms of the absolute amount of capital. But altering either the
numerator or denominator will change the ratio and reduce this shortfall.
How much of banks’ funding must be sourced from

capital?
According to internationally agreed standards (Basel III), banks must fund RWAs with
at least a certain amount of capital, known as the “minimum requirements” of capital
(Figure 1.5). In addition to the minimum requirements, banks will be required to have a
number of capital buffers.19 These are meant to ensure that banks can absorb losses
in times of stress without necessarily being deemed to be in breach of their minimum

capital requirements.
Regulatory capital standards comprise three parts or “pillars”. Pillar 1 sets out the
capital requirements for specific risks that are quantifiable. Pillar 2 consists of the
supervisory review process. It is intended to ensure that firms have adequate capital to
support all relevant risks in their business. Pillar 3 complements the other two pillars
and includes a set of disclosure requirements to promote market discipline.
What counts as “capital”?

Banks obtain funding by way of a variety of financial instruments. Figure 1.6 sets out
the components of eligible capital resources that correspond to Pillar 1 and Pillar 2
requirements. The main component of a bank’s capital resources is equity, referred to
as common equity Tier 1 (CET1). The key aspects of CET1 are the following:
it absorbs losses before any other tier of capital;
its capital instruments are perpetual; and
dividend payments are fully discretionary. Its main constituents are ordinary shares
and retained earnings.20
Appendix A explains how retained earnings feed into capital from an accounting
perspective. For the purposes of capital requirements, to calculate the amount of
CET1, adjustments are made to the accounting balance sheet. For example, items
which would give rise to double counting of capital within the financial system, or which
cannot absorb losses during stressed periods, are deducted.21
Banks can also count, to a limited extent, further instruments in their regulatory capital
calculations. So-called Additional Tier 1 (AT1) capital includes perpetual subordinated
debt instruments. Basel III standards require that AT1 instruments must have a
mechanism to absorb losses in a going concern, for example convertibility into ordinary
shares or write-down of principal when capital ratios fall below a pre-specified trigger
level.
A bank’s regulatory capital resource also comprises “gone concern” capital. Gone
concern capital supports the resolution of banks and the position of other creditors
such as the bank’s deposit customers in bankruptcy proceedings. This includes Tier 2
capital, which is dated subordinated debt with a minimum maturity of five years. In
addition, under Basel III, all additional Tier 1 and Tier 2 capital instruments must have a
trigger so that they convert into ordinary shares or are written down when the
authorities determine that a bank is no longer viable.22
Liquidity regulation
Microprudential regulation seeks to mitigate a bank’s funding liquidity risk – the risk
that, under stressed market conditions, the bank would be unable to meet its
obligations as they fall due. It aims to achieve this by incentivising – or requiring –
banks to have sufficiently stable sources of funding and an adequate buffer of liquid
assets. A useful analogy is the risk of a commercial building burning down: regulations
require both that the building is built to minimise the risk of fire breaking out (stable
funding) and that it has a sprinkler system to extinguish a fire should one occur (liquid
asset buffer).23 In other words: both to reduce the risk of the adverse event occurring
and to ensure that, if it does, the harm done is limited.
International liquidity standards have not yet been finalised and implemented. The
Basel Committee has agreed the first of two liquidity standards, the liquidity coverage
ratio (LCR).24 It is designed to ensure that banks hold a buffer of liquid assets to
survive a short-term liquidity stress. A second standard, the net stable funding ratio, is
designed to promote stable funding structures and is currently under review by the
Basel Committee. The rest of this section characterises the approach of the regulator,
although fundamentally this should be closely linked to a firm’s own approach in
managing its liquidity risk.
Prudential regulators need to consider how adequate a bank’s liquidity position would
be during a hypothetical stressed scenario. Such a scenario needs to consider the
various identifiable sources of liquidity risk in the banking business model, for example:
maturing deposits from retail and wholesale customers; triggers for a withdrawal of
funds relating to the bank’s credit rating; the amount of new lending to customers; and
the impact of increased market volatility leading to margin calls and non-contractual
obligations that mitigate reputational risk. The hypothetical stressed scenario is
typically of short duration (one to three months) and is a period of time during which the
regulator expects each bank to be able to survive with funding from the private
markets, without needing central bank support.
Typically, for the stressed scenario, regulators first of all determine the liquidity outflows
during the stress period. These depend on the mix of types and maturities of funding
that make up the bank’s liabilities. Depositors and counterparties are assumed to have
varying degrees of sensitivity to the creditworthiness of the bank and behave
accordingly. The assumption is that the most credit-sensitive depositors, such as other
banks, withdraw funding at a quicker rate than less credit-sensitive ones, such as
insured retail depositors. Other liquidity outflows may occur if adverse market
movements in respect of derivative positions mean that a bank is obliged to post liquid
assets as collateral.
The regulator then defines acceptable liquidity resources, which lie on the asset side of
the bank’s balance sheet. The regulatory definition of liquid assets stipulates the quality
of the liquid assets that banks must hold. The definition in force in the UK regime
comprises central bank reserves and high-quality supranational and government
bonds. As one bank may lend to another, or hold securities it has issued (unsecured
and secured bank debt), the liquid assets of one bank may be liabilities elsewhere in
the banking system. These are known as “inside liquidity”. In a financial market stress,
selling the debt of another bank is likely to prove difficult. Therefore, many regulatory
regimes exclude “inside liquidity” from the definition of liquid assets.
The relationship between a bank’s capital and

liquidity positions
There are a number of ways in which banks can alter their liquidity and capital
positions and there is no mechanical link between them. Even so, under certain
assumptions, changes in one might affect the other. The purpose of this section is to
illustrate some of the ways in which this could happen: in reality, the ultimate impact of
a change to one of these ratios will depend on a range of factors.
Two scenarios are considered in Figure 1.7. Relative to the baseline case, in scenario
1 the bank increases its risk-based capital ratio (capital as a share of RWAs). In
scenario 2, the bank increases its liquidity coverage ratio (liquid assets held to cover a
period of stressed net cash outflows). For both the scenarios considered, changes in
the relevant ratios come about via the mix of different types of assets and liabilities,
leaving the total size of the bank’s balance sheet unchanged:
Scenario 1: the bank increases its risk-based capital ratio by retiring short-term,
“flighty” funding from wholesale investors and issuing new equity of the same amount.
Its assets are unchanged.
Impact on liquidity: in this scenario, the bank’s liquidity position is also improved, since
it holds the same amount of liquid assets for a smaller amount of “flighty” wholesale
debt. Moreover, as Governor Carney has pointed out (Carney 2013), higher levels of
capital gives confidence to depositors and investors who provide funding to banks.
With more long-term, stable funding ensured, banks can safely hold fewer liquid
assets.
Scenario 2: the bank increases its liquidity coverage ratio by keeping its liabilities
unchanged and replacing illiquid loans (once these have been repaid) with liquid
assets such as gilts.
Impact on capital: the amount of capital is unchanged but, since the additional liquid
assets it now holds are assumed to have a lower risk weight than the loans they are
replacing, the capital ratio increases. These examples are intended to be purely
illustrative. As mentioned above, the actual impact of a change to one of these ratios
will, in practice, depend on a number of factors. If a bank seeks to improve its capital or
liquidity position then the total size of the balance sheet may not remain constant, as
assumed here. In scenario 1, for instance, if increased capital issuance is associated
with a higher aggregate funding cost, then the bank may choose to hold a different
amount of loans, either in absolute terms or relative to safer assets. Similarly, scenario
2 assumes that an increase in the liquidity coverage ratio gives rise to an improvement
in the capital ratio but one possibility is that, by holding a greater share of low-yield
liquid assets, the bank’s future profits may be lower (all else equal) and so the potential
for future increases in capital via retained earnings would be lower. In addition, the
examples do not take account of other important factors such as changes in the
perceived riskiness of a bank (and hence its funding costs and profitability) in response
to changes in its resilience as proxied by the capital and liquidity coverage ratios.
CONCLUSION
A key function of banks is to channel savers’ deposits to people that wish to borrow.
But lending is an inherently risky business. Understanding the concepts of a bank’s
capital and liquidity position helps to shed light on the risks the bank takes and how
these can be mitigated.
Capital can be thought of as a bank’s own funds, in contrast to borrowed money such
as customer deposits. Since capital can absorb losses, it can mitigate against credit
risk. In order to prevent balance-sheet insolvency, the more risky assets a bank is
exposed to, the more capital it is likely to need. Meanwhile, in stressed market
conditions, it is possible that banks find that they do not hold sufficient cash (or assets
that can easily be converted into cash) to repay depositors and other creditors. This is
known as liquidity risk. A stable funding profile and a buffer of highly liquid assets can
help to mitigate this risk.
Banks may prefer to operate with lower levels of financial resources than is socially
optimal. Prudential regulation seeks to address this problem by ensuring that credit and
liquidity risks are properly accounted for, with the costs borne by the bank (and its
customers) in the good times, rather than the public authorities in bad times.
APPENDIX A: “ACCOUNTING PRINCIPLES 101”

FOR UNDERSTANDING BANK CAPITAL
The accounts of a bank are the building block of capital regulation as they present an
audited view of its financial condition. This appendix describes some accounting
concepts relevant to understanding bank capital, including how provisions and retained
earnings feed into the balance-sheet and the capital position.
Balance sheets and income statements

A balance sheet shows a snapshot of the financial condition of a company at a given
point in time. A simple example for a bank is shown in Figure 1.1. Assets are recorded
in various categories (such as cash and central bank reserves, loans and advances to
customers and derivative financial instruments) as are liabilities (for instance, retail
deposit accounts and debt securities in issue) and capital (such as ordinary share
capital and retained earnings). A balance sheet must balance; resources (assets) must
equal the funding provided for the resources (liabilities plus capital). A company’s
income statement, meanwhile, shows its revenues and expenses (and certain gains
and losses) during a given period of time.
Losses, provisions, retained earnings and capital

Accounting rules require that losses on assets such as loans are recognised in the
form of impairment provisions as soon as they are incurred, but no earlier.25 Provisions
appear in two places in the accounts: on the income statement they appear as an
expense, reducing net income; on the balance sheet they appear as a reduction in
assets (in this case loans to customers) and a corresponding reduction in capital
(specifically, shareholders’ equity). The focus on losses arising from past loss events
has led to concerns that banks’ reported profitability and balance sheets may not
reflect adequately the economics of lending. Specifically, a bank recognises the
interest income that it receives from a loan as it is earned; but while some of this
income will reflect expected future losses that have been “priced in” to the loan (see
the main text for an example), these expected losses are not deducted elsewhere on
the income statement; only incurred losses are deducted. This risks overstating the
bank’s profitability in the period before the losses are incurred.
A recent proposal from the International Accounting Standards Board (IASB) aims to
respond to credit deterioration in a more timely fashion by requiring banks to build up
provisions earlier in the cycle and in advance of the losses being incurred.26 The
proposal recommends a staged approach to establishing loan provisions: from the
inception of a loan, provisions would be raised to cover expected losses arising from
defaults expected in the next 12 months. This 12-month loss estimate would be
updated as the probability of default changes and, where there has been a significant
credit deterioration since origination, the provision on the loan would be increased to
cover the full lifetime expected loss.27 This approach should result in a more prudent
assessment of banks’ profitability and capital. As with any forward-looking model, the
new approach would rely on some combination of internal models and management’s
judgements about expected losses.
Along with shareholder equity, retained earnings form a part of a bank’s capital base.
They also show up on both the income statement and the balance sheet. A simple
example helps to illustrate this. Suppose a bank makes a profit of £100 million in a
given period, which would be recorded on the bank’s income statement. As with other
firms, the bank can then choose whether to distribute this money to shareholders
(typically in the form of dividend payments) or retain it. If all of the £100 million is
retained, then this shows up as an increase in capital resources and, at least in the first
instance, as an increase in cash (or central bank reserves) on the asset side of a
bank’s balance sheet.28
Valuation of financial assets

Financial assets are assets such as cash and deposits, loans and receivables, debt
and equity securities and derivatives. The classification of a financial asset held by a
bank determines how it is valued on the balance sheet and how it affects the income
statement. The loans and receivables discussed above will generally be measured on
an “amortised cost” basis with income accrued over time, having deducted any
provisions for credit impairment. This is the typical “banking book” treatment. The
“trading book” treatment involves measuring assets on a current market price (that is,
“fair value”) basis.
These classifications mean that the market value of a bank’s assets may be lower (or,
in some instances, higher) than the amount at which the asset is recorded in the
accounts. This can be because there is no requirement to mark the assets to market,
although, where the market value is lower, it will also mean the bank has concluded
that the fact that fair value is below amortised cost is not evidence that the asset is
impaired. In such cases, the accounting equity would overstate the bank’s true capital
position and ability to absorb losses.
The authors would like to thank Guy Benn, Stephen Bland and John Cunningham for
their help in producing this chapter. This chapter is based on the Bank of England
Quarterly Bulletin article “Bank Capital and Liquidity” (see Farag et al 2013) and as
such will not reflect fully the regulatory developments since then.
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2/5/2019 Bank Capital and Liquidity - Risk.

Chapter first published in:

The Handbook of ALM in Banking

Bank Capital and Liquidity

THE TRADITIONAL BANKING BUSINESS MODEL

Introducing a bank’s balance sheet

Like non-financial companies, banks need to fund their activities and do so by a

Credit risk, liquidity risk and banking crises

CAPITAL AND LIQUIDITY

The difference between capital and liquidity: an

Sources of funding (liabilities and capital)

Expected and unexpected losses

Accounting for losses on the balance sheet

The leverage ratio

Liquidity crises: “runs” on banks

Mitigant (i): stable funding profiles

diversified across a range of sources,

Mitigant (ii): buffer of liquid assets

CAPITAL AND LIQUIDITY REGULATION

The PRA requires banks to have adequate financial resources as a condition of

This is a problem because it gives rise to a “negative externality”: excessive risk-taking

In addition to microprudential regulation, which is focused on the specific risks to

How much of banks’ funding must be sourced from

in times of stress without necessarily being deemed to be in breach of their minimum

What counts as “capital”?

it absorbs losses before any other tier of capital;

its capital instruments are perpetual; and

The relationship between a bank’s capital and

APPENDIX A: “ACCOUNTING PRINCIPLES 101”

Balance sheets and income statements

Losses, provisions, retained earnings and capital

Valuation of financial assets

Bank of England, 2013b, “Strengthening Capital Standards: Implementing CRD IV”,

Bank of England, 2013c, “Financial Stability Report”, June.

Basel Committee on Banking Supervision, 2011, “Basel III: A Global Regulatory

Brunnermeier, M. K., and L. H. Pedersen, 2008, “Market Liquidity and Funding

Dewatripont, M., and J. Tirole, 1994, The Prudential Regulation of Banks

Diamond, D. W., and R. G. Rajan, 2000, “A Theory of Bank Capital”, Journal of

Goodhart, C., and E. Perotti, 2012, “Preventive Macroprudential Policy”, VoxEU.org,

Copyright Infopro Digital Limited 2017. All rights reserved.

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