Capital serves as a buffer to absorb unexpected losses as well as to fund the ongoing activities of a bank. Losses will occur in the normal course of business. When making a loan, or selling any product, a bank will take account of expected losses when determining the price to charge the customer. The bank's income should therefore cover expected losses, as well as any other costs associated with the day-to-day running of the business. Unexpected losses are by their nature unforeseen, so banks will need to hold enough capital to act as a buffer against these losses and to support them during periods of financial stress.
In general, banks hold capital as a mixture of ordinary shares (equity) and debt instruments (such as loan notes) that meets the risk and reward preferences of equity shareholders and debt investors. A bank's capitalisation and gearing are crucial market indicators for potential investors, as well as rating agencies and other interested parties.
Banks often have long term assets, funded by shorter term deposits and liabilities. This can lead to liquidity problems in periods of market turbulence, particularly where banks may have to service large depositor withdrawals. In these circumstances, regulations such as minimum capital requirements help a bank to remain solvent and contribute to its ability to withstand liquidity problems. Given the importance of deposits to consumers and the role of banks in maintaining economic stability, all banks regulated by the FSA are required to hold a minimum amount of capital, usually expressed as a percentage of the value of a bank's risk-adjusted assets.
FSA regulations on capital operate to protect depositors in two main ways:
■ By requiring banks to hold capital capable of absorbing unexpected losses while the bank is solvent, thus reducing the probability of a bank failing. Even if there is no loss to depositors when a bank fails, the disruption caused through any temporary difficulty in accessing funds could cause distress for consumers;
■ If a bank does fail, capital acts as a buffer in protecting depositors' claims in insolvency. This is achieved by ensuring that capital is subordinated to the claims of depositors. Loss to depositors is minimised, since the first losses will be suffered by the investors in regulatory capital. Such "gone concern" capital also protects other senior creditors and therefore promotes confidence in the financial system.