Companies in all industries face various risks and hold capital or equity in case these risks materially impact the future financial performance of the company. Equity act as a buffer to absorb future losses and to ensure that their assets are always greater than their liabilities for a bank. Assets can decrease in value because loans which are an asset to the bank default or are not repaid in full. Also, assets can decrease in value because financial assets such as derivative contracts can decrease in value through movements in their market value. Cash, another asset to a bank might decrease if the bank has to make payments for regulatory fines or compensation.
In all cases, the decrease in the value of the assets is absorbed by the equity the bank holds.
Let's have a look at what impact a bank's leverage has on the returns it generates for its shareholders.
Banks generate returns from the assets they hold on their balance sheets. These assets are funded by liabilities such as customer deposits or debt financing, which have an interest cost and by the equity itself.
In this simplified example, return on assets or ROA is calculated by dividing the operating profit by the value of the bank's assets. Let's look at the low leverage bank, which let's say earns 5% interest on. Its 1000 of loans and pays 3% interest on its 800 of liabilities, deposits and debt financing, meaning the return from assets is 1000 times 5% or 50 less the cost of the liabilities, which is 800 times 3%, or 24. This gives an operating profit of 26 and an ROA of 2.6% when that operating profit is divided by the 1000 of assets that they have. Assuming this operating profit is all attributable to the shareholders by multiplying the ROA by the bank's leverage calculated by dividing assets by equity, the return to shareholders called the return on equity or ROE can be calculated since the assets of 1000 will be canceled out.
For the low leverage bank, it's assets are 1000 and equity is 200, meaning its leverage is 5 times multiplying the ROA of 2.6% by the leverage ratio of five gives an ROE of 13%. This could also be calculated by dividing the operating profit of 26 by the 200 of equity.
A bank can increase its ROE by holding less equity, which in effect increases the bank's leverage. This will result in a reduction in the ROA since, as you can see from the high leverage bank on the right, which has liabilities of 900 rather than 800. For the low leverage bank, the return on assets drops to 2.3%. Since there is more interest to pay on the higher level of liabilities, however, this increase in leverage will please the bank's shareholders, since the fall in ROA is more than offset by the increase in leverage from five times to 10 times. The downside of this increase in ROE is that the buffer that protects the bank from bankruptcy is now smaller, which could put the bank in danger as a going concern should future losses be larger than expected. This is why there are regulations in place around a bank's equity capital levels to stop banks holding too little capital with the aim of increasing their returns to shareholders, ignoring the potential increase in risk of bankruptcy that this exposes the bank to. It is important to make the distinction between the two different types of capital. The capital on a bank's balance sheet, usually called equity is accounting capital, and it can generally be thought of as the difference between the market value of the bank's assets and the market value of the bank's liabilities. This will be calculated using the appropriate financial reporting standards and is expressed in monetary terms. Regulatory capital refers to the amount of capital that a bank needs to have in order to meet regulatory requirements, which are designed to reduce the risk of bankruptcy should future losses be higher than expected.
One of the biggest differences between accounting capital and regulatory capital is that regulatory capital does not include goodwill. This is because in the event of a bank going bankrupt, the goodwill on its balance sheet will be worthless. The goodwill in part represents the present value of the future profits from acquisitions, and since the bank is near bankruptcy, there's unlikely to be any future profits. How much regulatory capital a bank is required to hold is driven by its risk weighted assets or RWA, which takes into account the amount as well as the riskiness of a bank's assets. A bank's minimum regulatory capital requirements are typically expressed as a percentage of the bank's risk weighted assets.
