What is Capital Risk in Banking?

What is capital risk in banking?

Capital risk refers to the possibility of a bank finding that it needs to absorb a loss. A healthy bank will have the capital to do so despite having used deposits as the basis for creating money in the form of loans to borrowers. That is, most depositors assume that a bank will always be able to honor their deposits, a basic liability. In reality, depositors claiming their funds all at once, a classic bank run, has the power to destabilize banks, especially those overextended in risky investments. 

Using a worst-case scenario may be recommended in managing capital risk. These scenarios, or modeling tools, help the bank plan for loss potentials in realistic ways, ultimately strengthening the bank’s position. Which types of risks should a bank model?

Three main risks to bank capital include credit risk, market risk, and operational risk. Put simply, credit risk pertains to the threat of default from borrowers. This may be the largest risk type a bank faces, as the extension of credit to borrowers is one of the primary ways many banks produce income. 

Market risk pertains to fluctuating rates of interest rates – both domestic and in foreign exchange – and the prices of commodities and equities. Supply and demand predictions can be hard to divine, so market risk is important to pay attention to when seeking to limit overall exposure. 

Operational risk describes the results of what is sometimes defined as internal or external fraud, employment issues such as workplace compensation or safety claims, system failures, poor processes, physical damages to assets sustained for any reason, and more. Excellent controls, procedures, education, and both physical and technological security are vital in managing operational risk, though the resulting analysis of exposure will never show this risk has disappeared completely.  

Why does imposing bank capital requirements on banks help limit risk-taking?

According to one congressional research report, “Capital requirements are a key prudential measure that banks must meet in order to operate in a safe and sound manner.” How so? Capital can cushion a bank facing both hostile environments in many forms and the potential for eroded asset value during a downturn or crisis.

Liquidity, specifically, can be maintained to hedge against sustained losses and increase confidence in the bank. Certain amounts of bank liquidity are mandated. The purpose of such mandates is simply to ensure that the bank is not investing all of its capital in risky investments which may lead to bank failure. Using solvency as a solution, capital requirements demand that banks are able to quickly produce funds to cover specific amounts. 

Currently, the Federal Reserve Board requires all large banks and financial institutions to have 4.5 percent available as their capital requirement. Large banks are defined as those with $100 billion or more in assets. Larger banks often have heftier capital requirements because of their place in the larger banking system. Their failure could cause other banks to follow suit in a kind of contagion of collapse. Requirements are maintained despite critics pointing to their ability to throttle the bank’s power to invest. This lower investment leverage, in turn, could hamper the bank’s power to lend and provide credit to individuals and businesses, say critics. 

Bank Credit Risk vs. Bank Capital Risk

Bank credit risk is the potential that those who borrowed money will not be able to pay it back or default. According to the Office of The Comptroller of The Currency (OCC), this risk “arises any time bank funds are extended, committed, invested, or otherwise exposed through actual or implied contractual agreements.” Capital risk is much broader, though it intertwines with credit risk and other risks banks face. 

So, how liquid is your bank, and how liquid should it be to cover capital risk? Regulations can help guide you in this case, with further details ensuring that you are aware of why and how to comply. Both new and seasoned bank professionals can learn more about capital risk with Noggin Guru.