Capital Requirements

I was driving home from class tonight and heard part of an episode of Fresh Air on NPR. Terry Gross was interviewing a journalist from The New York Times about AIG. They were going through the notable topics of the nice ride that AIG has given us around the block, how much they paid the drivers, how much change is falling out of our pockets into the back seat, and so on.

Anyway, the guest used the term "Capital Requirements" a number of times. Lots of other media folks use it too, but I'm not confident many people know what that means.

A little setup:
The US government lends money directly to private banks. Other countries do it too and it happens every day, not just in times like now. I'll explain how that all works another day. Banks generally take this money and lend it to other banks. Banks also borrow from other folks (your savings account) and lend it to others (your brother's car loan). This is a big way that banks make money: borrow money from someone at one rate and lend it out someone else at a higher rate.

Another setup point:
These banks are somewhat protected by the same government that lends cheap money to them. At the very least, their depositors (you and your checking/savings/CD account) are protected through the FDIC if the bank goes bankrupt. They might also be deemed "too big to fail," which has other protections that are harder to specify.

Now, imagine you decide to go start one of these banks. You set up shop, borrow money from the government, lend it out to your brother and his friends, and take a tidy profit home every night. Think about this for a minute and you will probably start doing it more and more. All you need is some cash to run the office and do marketing, and you can ride the borrow-lend-profit train all the way home. Not only that, but if things go badly for your bank (your brother's friends are deadbeats) you can just close up shop and let the government take on the losses. You lose the bit of cash you were using to pay your expenses, but you can go start another bank tomorrow with the rest of your money.

The government can see this plan as clearly as we can, so they protect against that. They require that banks put a few cents in the game for every dollar that is lent. The number of cents changes, depending on the bank, the type of lending it is doing, the economy, politics, etc. This helps to make the incentives right. If a bank has to put $10 million of its own money on the line to borrow $90 million from the government, the bank won't just lend out the $100 million willynilly. It will try to make good and profitable loans, because it knows that it will lose its $10 million if things go bad. In fact, that $10 million is supposed to be the first money that is lost when things go wrong.

Those cents are the "equity" and the dollar borrowed is a "liability." These are both parts of the capital structure of the bank, which is why these are called Capital Requirements.

If you've bought a house with a mortgage, this probably sounds familiar to you. Your down payment was a capital requirement. That hard earned cash in your house is one of many things that motivates you to keep the building and property in good shape, because if you sell the house for less than you bought it you will be the one to take the first loss.