What are Risk Weighted Assets

Why do banks have to hold equity?

23 May 2019

Equity is a prerequisite for a safe and sound banking sector. This is because banks take risks and can suffer losses if those risks materialize. In order to be on the safe side and to protect the deposits of their customers, banks must be able to absorb such losses and to survive even in difficult times. Bank equity is used for this.

But how much should a bank's equity be? That depends on the risks she's taking. The greater the risks, the more equity the bank needs. It is therefore very important that banks continuously assess existing risks and potential losses. These assessments are being critically examined by the banking supervisory authority. The supervisor is responsible for overseeing the financial health of banks, with capital adequacy reviews playing an important role.

What exactly is bank equity? How does it ensure safe banks in the long term? And how high does the equity capital of banks have to be?

What is Equity?

Put simply, equity is the money a bank has received from its shareholders and other investors. This also includes undistributed profits. So if a bank wants to increase its equity base, it can do so, for example, by issuing additional shares or by retaining profits instead of distributing them to shareholders in the form of dividends.

Overall, every bank has two sources of funding, namely equity and debt. Debt is the money that the bank has borrowed from its lenders and must repay. Debt capital includes, but is not limited to, customer deposits, debt securities issued, and bank loans.

The funds from these two sources are used by the bank in a variety of ways, for example to extend loans to customers or to make other investments. Together with the cash on hand, these loans and other investments constitute the bank's assets.

How does equity ensure safe banks in the long term?

Equity acts like a financial cushion against losses. For example, if numerous borrowers are suddenly unable to repay their loans or if some of the bank's investments lose value, the bank will suffer a loss. Without an equity cushion, it could even face bankruptcy. However, if the bank has a solid capital base, it will use this to absorb the loss, continue its business and be there for its customers.

How much equity do banks have to hold?

In the context of European banking supervision, the capital requirements for a bank consist of three main elements:

  • the minimum capital requirements (pillar 1 requirements),
  • an additional capital requirement (pillar 2 requirement)
  • and the capital buffer requirements.

First, all banks that are subject to European banking supervision must comply with European legislation that sets the minimum capital requirement (Pillar 1 requirement) at 8% of the bank's risk-weighted assets. But what are risk-weighted assets? It is the total assets of a bank, multiplied by their respective risk factors (risk weights). The risk factors provide information about how risky an asset is. The less risky an asset is, the lower its risk-weighted amount and the less equity a bank needs to hold to cover the risk associated with the asset. For example, a mortgage loan secured by an apartment or house is less risky than an unsecured loan and therefore has a lower risk factor. As a result, the bank has to hold less equity for such a mortgage loan than for an unsecured loan.

Second, there is the additional capital requirement set by supervisors (Pillar 2 requirement). This is where European banking supervision comes into play. Supervisors of the ECB and the supervisory authorities of the participating countries take a close look at individual banks and assess the risks to which they are exposed. This takes place as part of an annual supervisory review and evaluation process (SREP). If the supervisors come to the conclusion that a bank's risks are not adequately covered by the minimum capital requirements, they will be asked to hold additional equity capital.

Both the minimum and the additional capital requirements are binding and non-compliance has legal consequences. These depend on how serious the violation is. For example, the regulator can ask the bank to develop a plan that illustrates how the capital requirements will be met again in the future. In the event of a very serious breach, the bank can lose its authorization.

According to the third capital requirement, banks must have additional buffers for different purposes (for general capital maintenance and for protection against cyclical and non-cyclical systemic risks).

In addition to these three types of capital requirements, the supervisors expect the banks to hold a certain amount of capital for periods of stress (Pillar 2 recommendations).

Banks should determine for themselves how much equity they need in addition to the amounts required by supervisory and regulatory authorities in order to pursue their business models on a sustainable basis.