Main Content

Topical Terms in Economics

Core Capital

Core capital is the most liable component of balance-sheet equity of a bank. It serves as the assessment basis for the recognition of additional capital components as parts of liable equity capital. Implicitly, the available core capital defines the upper limit for the sum of the risk-weighted loans of a bank.

Background

In order to guarantee the economic stability of banks, banking regulators require that banks hold a specific portion of equity capital, which in the case of losses can serve as a buffer before a bank can no longer comply with its payment obligations. According to the stipulations of the Basel II accord, this portion must be at least eight percent of the risk-weighted loans, which means that a bank may loan a maximum of 12.5 times its equity capital as (risk-weighted) credit.

Equity capital, however, consists of various positions that differ according to their debt covering ability. In particular a distinction is made between core capital and supplementary capital. Core capital includes own resources that are permanently available to the bank and thus have the highest quality in terms of liability. This comprises especially share stock, capital reserves (payments from capital increases that exceed the denomination of the new stocks), profit reserves and silent deposits (capital contributions by silent partners). Deducted from this are all immaterial assets such as patents, copyrights and licenses but also a bank’s “goodwill”. Supplementary capital includes non-realised profits from bonds, certain value adjustments and preferred shares.

Core capital rate

In order to assess a bank’s risks, its core capital is examined in relation to its risk-carrying investments. The higher the core capital rate so determined, the better the bank can cope with possible losses. A core capital rate of at least seven percent is generally regarded as an indicator of a healthy bank balance sheet.

The minimum core capital ratio in Germany can be gleaned from the regulations that are in effect,[1] according to which supplementary capital can be taken into consideration for the calculation of liable equity capital only to the same amount as the core capital (Art. 10, Sec. 2, Paragraph 3 of the Banking Act of the Federal Republic of Germany, KWG). This results in the obligation to maintain a core capital rate of at least four percent of the risk-weighted loans.

In general, however, the Federal Office for Financial Service Supervision (BaFin) takes action as soon as a bank’s core capital rate falls below five percent.

Economic criticism

In the financial crisis of 2008 and 2009, it became evident that the equity capital of many banks was not sufficient to offset the losses from transactions with mortgage-backed securities.

The Basel I system required banks to maintain an eight-percent equity capital ratio and a core capital rate of four percent of the total balance sheet. After the Basel II Accords took effect in the EU in 2008, this rate referred to the risk-weighted assets. Accordingly, loans to banks from EU countries were given a weight of 0.2; i.e. they were only counted as 20 percent in the calculation of risky loans. Credit to EU countries, with a weighting of zero, did not have to be backed up at all with equity capital. A weighting of more than one only applies for businesses with a junk-bond rating of worse than BB-. This method of calculation resulted in many banks in Germany and Europe being able to declare a healthy core capital ratio of more than seven percent although they had in part reduced their balance sheet equity capital to less than two percent.[2] At the same time the weighting distorts the interest-rate structure. States can take on debt on too favourable terms whereas businesses must pay too much for their loans. This distortion leads to a misdirection of capital flows and contributed to the debt crisis of the GIPS countries.

In order to more effectively protect the banking system from future crises, in addition to raising the core capital rate an adjustment of risk weighting is particularly necessary. On average for all banks, the sum of the risk positions should correspond approximately to the respective balance-sheet total. The fear that stricter capital requirements could harm the economy by making credit more expensive is unfounded. On the one hand, the rise in interest is limited since, after a sharpening of the equity capital requirement, the banks’ lenders will be content with lower interest since they are now bearing a smaller risk. On the other hand, a rise in interest rates that comes about because the banks can no longer pass on their losses to the taxpayer in times of crisis is not a disadvantage but an advantage, since it would come about via an internalisation of a negative externality to the taxpayers. Prices, and also interest rates, can be too high and too low in an economy. Both lead to welfare losses.

Basel III

In the wake of the 2008 financial crisis, the Basel Committee on Banking Supervision at the Bank for International Settlements issued recommendations in September of 2010 pertaining to how the equity capital requirements for banks can be improved.[3] These recommendations – generally referred to as Basel III – call for an increase in the core capital ratio from four to six percent by 2015 – and to 8.5 percent by 2019. In addition, it calls for testing a 3% ratio of Tier 1 capital to the bank’s total non-weighted assets plus off-balance sheet exposures, which would limit banks to a leverage factor of 33.

These stricter capital requirements are welcome. Banks must now create a larger buffer for difficult times. And the banks’ shareholders must bear a larger portion of the insolvency risk in future. As a result they will demand more cautious business models from the bank managers. However, based on the experience from the financial crisis, the new rules are not sufficient. In the financial crisis, many banks incurred far greater losses than what Basel III requires as a buffer. By the beginning of 2010, Citigroup had lost about 6 percent of its balance sheet total as a result of write-offs of toxic financial products; for Wachovia it was 13 percent, for Merrill Lynch 6 percent, for Washington Mutual 14 percent, for the Bank of America 5 percent and for Wells Fargo nearly 8 percent. In Europe HBOS plc and the Bavarian State Bank (BayernLB) lost about three percent of their original balance-sheet total; the semi-public IKB Deutsche Industriebank suffered a loss of 19 percent.

Another flaw is that Basel III has not changed the risk weighting for the different kinds of debtors. In spite of a more critical assessment of countries by the rating agencies, loans that banks make to countries such as Italy, Ireland, Spain, Cyprus or Belgium still have no risk weighting. Only loans to Greece and Portugal are assessed in the Basel system as special risks because of the massive downgrading by the rating agencies. For loans to the other EU states, only the new balance sheet/capital asset ratio applies. The regulation moderates the distortion of the interest-rate structure and it will lead to small businesses being able to obtain credit on more favourable conditions in future, since the higher interest on government bonds will bring about higher yields to the banks’ necessary equity capital.[4]

 


[1] Art. 2, Sec. 2 SolvV and Art. 10 Sec. 1d, paragraph 1 KWG
[2] See Hans-Werner Sinn, "Casino Capitalism“, OUP, Oxford 2010, pp. 137ff.
[3] See BIS press release of 12 Sept. 2010
[4] See Hans-Werner Sinn "Basel III: Stricter and Fairer“, The Ifo Viewpoints 2010, Ifo Institute, Munich, 2010, no. 118