The purpose of capital for institutions with government-insured deposits

Abstract

Capital has two basic meanings that are not interchangeable, which gives rise to much confusion. Capital can refer to assets, such as plant and equipment. It also refers to the other side of the balance sheet, to claims over the assets. In banking, "capital adequacy" usually refers to stockholders' equity, although for purposes of deposit insurance, debt claims that are not guaranteed, de jure or de facto, by a federal government agency also should be considered. Indeed, as is shown below, such debt claims are superior in several important ways to equity capital. When people say that "banks a are overcapitalized" or"there is too much capital in the banking industry," they could be referring to the asset or the liability side of the balance sheet. If their concern is with the asset side, they would be calling for mergers of banks that would reduce physical plant size, loans, and investments. If they mean the equity and nongovernment insured debt portion of the liability side, they would be claiming that the federal deposit insurance agency (hereafter, the FDIC 2) is not sufficiently subject to risk, either from the point of view of the owners of banks or for social purposes (e.g., to offset externalities from bank runs or to optimize the quantity of bank money and financial intermediation). If they mean only the equity portion of the liability side of the balance sheet, they could mean that the bank should hold more debt that is de facto as well as de jure uninsured (usually called subordinated debentures) in the same sense that nonbanks are said to have suboptimal debt/equity ratios. 3 One reason that the two concepts might be confused is that they are related, as the assets in which a bank invests and regulatory restraints on these investments are important determinants of the cost of debt and equity capital. For example, laws and regulations that prevent banks from diversifying their assets efficiently increase risk and the cost of equity capital. Underpriced federal deposit insurance gives rise to an intangible asset, the deposit insurance put option. This linkage might be the source of some confusion. In the balance of the article, I first consider capital as assets and then capital as equity and uninsured debt. Capital here and throughout the paper is assumed to reflect well economic market values. As presently reported, capital is an accounting construct that often badly measures market or current values of assets and liabilities. Although a thorough discussion of market value accounting for banks is beyond the scope of this article,