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Bank capital has several functions. It promotes public confidence, it restricts unwarranted asset growth.
It provides protection to the depositors and gives insurance funds and absorbs the losses.
Capital allows institutions to operate at the time of financial difficulties. It helps even those firms that operate losses or serve at the time when companies face adverse financial results.
Such a capital provides a measure of assurance to the public which an institution can provide even when losses have happened and this helps in enhancing confidence in the banking system and also reducing liquidity concerns.
The FDIC is the primary organization responsible for protecting deposits and insurance funds. Bank examinations are conducted by its supervisory bodies that help it to review bank policies, the management qualifications, and performance to identify weaknesses, which could hinder earnings or capital.
The examiners handle bank’s earnings, contingent liabilities, and effects on capital that arises from banking relationship, trust activities, and litigations.
Bank regulatory capital is determined to limit risk and reduce the chance of losses.
The regulatory capital requirement helps the bank to absorb sufficient losses through shareholder's equity rather than from customer’s deposits or other sources.
These regulatory capital requirements are determined in the manner to ensure that the revenue or assets do not grow like the in-hand money, while, one cannot assume the payout ratio for given stock repurchase.
Financial companies issue loans to businesses and individuals and if those individuals and business default, the bank loses money.
The main forms of capital held by banks include Common equity CE Tier 1 capital, Tier 1 capital, and Tier 2 capital.
The Tier 1 Capital Ratio is calculated in asset management and investment banking by taking a ratio of the bank’s core capital relative to risk-weighted assets.
The ratio was introduced in 2010 after the 2008 crisis as a measure of the bank’s ability to handle financial distress.
The total capital is represented as a sum of Tier 1 and Tier 2 capital.
In 2010, the Basel Committee proposed a new standard for the two systems where the banks determine their tiers and capital ratio.
The banks having too much debt and low levels of equity lack adequate capital to absorb the losses.
In 2013, the FDIC, OCC, and FRB issued regulations for insured depository institutions in the US which aligned with the Basel III capital standards.
These standards were designed, mainly, to strengthen the quality and quantity of bank capital to promote strength in the financial industry to get asset classes risk and return to make it resilient against economic stress.
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