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.
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.