Financial Crisis Evolution Of Bank Capital - 3146 Words

TABLE OF CONTENT: Introduction 2 Defining Bank Capital 2 Measure of Bank Capital How Capital Absorbs Risk 2-4 †¢ Covers Credit Risk †¢ Prevents Liquidity Problems †¢ Manages Operational Risk †¢ Restricts banks from taking excessive risk Manipulation of Capital Standards 4-7 †¢ Quality of Capital Resources †¢ Internal Rating Based (IRB) approach under Basel-II †¢ Securitization †¢ Credit Derivatives†¦show more content†¦Capital in banks play an essential role of helping banks remain solvent by absorbing losses caused due to stress conditions. In this paper, we shall analyse how capital helps banks manage their risk, what led to banks failing during the financial crisis and what measures have been adopted to avoid (or better manage) such situations in future. DEFINING BANK CAPITAL Banks’ capital is defined to be the difference between the assets and liabilities of a bank. It is the net worth of the bank or its value to investors. It is stated along the liabilities side of the balance sheet. Main characteristics of bank capital †¢ No contractual repayment requirements: Unlike other liabilities, bank capital is perpetual. As long as bank continues to be in business, it is not obliged to repay the shareholders. †¢ Low priority in case of bankruptcy: In case of insolvency or bankruptcy, capital investors only receive what remains after paying all the creditors. Capital generally ranks low in case of claims as compared to most of the other claimants. Constituents of bank capital †¢ Tier 1 Capital also known as core capital includes permanent shareholders’ equity and disclosed reserves. †¢ Tier 2 Capital (supplementary capital) includes undisclosed reserves, revaluation reserves, general provisions, hybrid capital instruments and subordinate term debt subject to certain conditions.