Managing Bank Capital: Capital Allocation and Performance Measurement, 2nd Edition

1

The Role of Capital

While industrial and consumer products companies seek to avoid risk, financial firms have to seek out risk to make money. This difference is a key to how financial firms can prosper. Risk permeates everything they do.¹

This section of the book examines the role of capital in a financial institution, and the various definitions that exist. In particular, it introduces the very important distinction between funding and capital, which is virtually unique to financial institutions and which is vital to an understanding of the subject of capital management—a theme which is taken up in more detail in Part Two. In addition to this summary chapter, Chapter 2 introduces all of the important concepts of capital management, and compares the textbook approach to capital at non-financial firms with the modifications required to understand financial firms.

I start this chapter by asking two simple but important questions: Why do banks hold capital? And why are those capital levels important? These are not just academic questions: the more capital banks have to hold (in the form of equity), the more difficult it is to generate the return required by shareholders.

In order to answer the question: “Why do banks hold capital?” it is first necessary to review the forces behind the development of capital standards. I will then attempt a definition of the role of capital in a financial institution, and examine some of the consequences of this definition. I will also ask the ...