How Asset Losses Reduce Bank Capital and Increase Leverage

# Asset vs capital


# Asset vs capital












In easy money 3 there is an example given about asset to capital ratio of a bank. I'm confused in two things.

The example: Say a bank has 100\$ in assets and 2$ in capital. If the asset value depreciates 1\$ so it now is worth 99\$ then it loses half it's capital. First, It's assets essentially equivalent to capital. I know assets generally are less liquid but this is still 99/2 = 49.8 ~= 50.

I'm deducing that by "it loses half it's capital" to mean that it has to go buy 1\$ in assets to make of for it's loss so now one has 100\$ assets and 1\$ capital and this gives a ratio of 100. This is very different than 49.8. Yet in both cases the "value" is 101\$.

The example makes it seem that when they lose \$1 in assets they lose 1\$ in capital which is really a loss of 2\$ overall.

2nd, why could it not just sell 1\$ in assets to 1\$ in capital so one has 98$ in assets and 2\$ in capital which gives a 48/2 = 49 ratio.

So basically there is a discrepancy between how assets and capital are treated. (A + x)/(C - x) where x can move freely between assets or capital("buying or selling") can change the ratio tremendously without changing the overall value which is (A + x) + (C - x) = A + C.

I assume then what makes all the difference between the two has to do with liquidity and hence x is not "free". I assume the risk is defaulting and even 1 cent in default then blow everything up? Even if the bank has an infinite amount in assets, if they have 0 capital they cannot function and someone else gets those infinite assets for free?

In my mind it makes zero sense why, say, a bank with 0 capital but say, 100T in assets could be infinitely "leveraged". It would seem to me the real leverage is A/(A + C) but I am assuming assets can capital are essentially the same thing on some level.

What I don't get is why a decrease in assets somehow effects the capital. If I have 10k in the bank and my 100k house depreciates by 10k I don't end up with 0k in the bank and a 90k house(or 100k house). Yes, I've lost 10k but it's a loss overall.

What am I missing?

## Answer by Attack68 (score 2)

https://quant.stackexchange.com/a/79679

Basel has clear definitions for capital of a bank. There is:

- Tier 1 Capital (going concern capital)

- Tier 2 Capital (gone concern capital)

Common Tier 1 capital (CET1) is predominantly composed of ordinary share capital (not market cap) plus retained earnings. Certain items subject to criteria get added to CET1 capital to make up the whole of Tier 1 capital, e.g. AT1 bonds.

Suppose you start a bank with \$2 of ordinary share capital. I.e the owners invest \$2 of their own money. Their initial balance sheet will look like:

[Assets: \$2 (cash), Liabilities: \$0, Capital: \$2]

Acting as a bank you extend leverage and create broad money supply (i.e. you create a mortgage asset and deposit funds in your customers accounts as liabilities). Your balance sheet is now:

[Assets: \$102 (cash + mortagages), Liabilities: \$100, Capital: \$2]

If the assets fall by \$1 your capital will fall by half.

[Assets: \$101 (cash + mortgages), Liabilities: \$100, Capital: \$1]

This can be seen in one of two ways, either that the sum of assets and liabilities must equal shareholders funds + retained earnings, or recognising that assets falling by \$1 will be accounted for (at fair value accounting) as a \$1 loss and is passed through to retained earnings, which falls under the definition of Common Tier 1 capital described above.