1 Answers
Academics, practitioners, and regulators all recognise and agree that capital is required for banks to operate smoothly because capital provides protection. The critical question is how much, and what type of, capital a bank needs to hold so that it has adequate protection.
In the simplest form, capital represents the portion of the bank's liabilities which does not have to be repaid and therefore is available as a buffer in case the value of the bank's assets decline. If banks always made profits, there would be no need for capital. Unfortunately, such an ideal world does not exist, so capital is necessary to act as a cushion when banks are impacted by large losses. In the event that the bank's asset value is lower than its total liabilities, the bank becomes insolvent and equity holders are likely to choose to default on the bank's obligations.
Naturally, regulators would hold the view that banks should hold more capital, so as to ensure that insolvency risk and the consequent system disruptions are minimised. On the other hand, banks would wish to hold the minimum level of capital that supplies adequate protection, since capital is an expensive form of funding, and it also dilutes earnings.
There are 3 views on what a bank's minimum capital requirement should be.