Why do banks need capital?
The 2007/8 global financial crisis showed us what can go wrong when the banking system has too little capital. The Government had to bail out some UK banks. Others got into severe financial difficulties. As a result, the UK economy suffered its deepest recession for 80 years with huge costs to society.
How much capital is enough?
It varies from bank to bank. However, current capital rules are much tougher than those before the financial crisis. Under the new rules, the world’s biggest banks need to have much more capital than before because their financial losses would have a bigger impact on the economy. The greater the risks, the more capital required.
The first step to working out how much capital a bank needs is to add up all of its assets. These assets includes loans (such as mortgages or personal loans) and securities (such as shares and bonds that the bank owns) because these are the areas where it could lose money.
The next step is to make the bank set aside a percentage of these assets as capital to pay for potential losses.
A bank can increase its capital by:
- Holding back some of the money it makes during good times rather than paying it out to investors as or to staff as bonuses.
- Selling some new shares to make money.
Stress testing also supports the banking sector
Rules aren’t enough to guarantee a safe and sound banking sector. So we carry out stress tests to see if banks are strong enough to cope with extreme economic situations.
It is crucial banks are strong and keep lending money if the economy goes into a downturn to prevent any damage spreading.
Bank of England's KnowledgeBank guide on stress-testing
Hi my name is Noor and I work at the Bank of England. Here at the Bank of England, we need to keep an eye on how banks would cope with difficult economic situations. We do this by stress testing banks, against various hypothetical scenarios. The Bank of England then ensures that should these situations occur, banks hold sufficient capital to meet unexpected losses.
From 2016, we will use two ‘what if’ scenarios to test banks. The first will be a yearly test of shock scenarios of different levels of severity, based on the UK's current economic cycle. The annual cyclical scenario could include falls in output or house prices or increases in interest rates or unemployment. The second will be an exploratory scenario every two years. This scenario will look at risks that are unlikely to happen but are still a concern, for example what might happen if a large bank fails. Banks have always been required to hold a minimum amount of capital to absorb losses but from 2016 how the Bank of England looks at stress test performance is changing. With larger and more risky banks needing to carry more loss absorbing capital.
Should a bank not perform satisfactorily, the Bank of England has a range of powers, such as requiring the bank to take action to strengthen its capital position within a certain period of time.
Does this mean banks can’t go bust?
Like any other company, a bank may go bust if it runs into financial trouble or isn’t sustainable as a business anymore. If this happens, the bank’s investors should foot the bill and not taxpayers. So in the UK, if your bank fails you can claim back up to £85,000 of your money through the Financial Services Compensation Scheme.