Your answer to Michael Pollack was on and off. Too compressed, I should say.
Bank capital is essentially money that the bank does not owe to anyone, because the investors have put it at risk (theoretically).
You 'n' your friends raise $1m, you file papers to open a bank. You make loans for $9 million (which increases your deposits by as much). Your $1 million capital will serve to cover the odd person who chooses to have cash instead of a deposit. The return on equity will be calculated against the $1m invested. So $9 million lent at 8% will gross $720,000 some portion of which will be paid out as dividends to the original investment group. The capital asset ratio of this bank is 1m (capital)/9m (loans) which works out to a bit less than ten percent.
It is true that in actual practice you won't need to keep $1m "cash" to cover the bank operations and so some of the capital can be invested in a "good as cash instrument." Regulators recognize a govt bond as such. So the bank capital could be invested in a govt bond and then serve as the "anchor" for the rest of the bank's activities.
The bank could however receive additional money in the form of deposits and choose to invest these in government securities. These would be govt bonds but they would *not* be bank capital. As the bank attracted additional depsoits and made loans (keeping a cash reserve on the deposits which is also not "bank capital") its capital/asset ratio would decrease. International standards adopted in the early 90s set these somewhere around 5-7% as I recall. So at some point as a bank expanded it would have to increase its capital, possibly through retained earnings or by selling new shares to investors. The money thus raised as capital could be kept as cash or invested in a limited range of acceptable instruments, e.g., govt bonds. Probably not all govt bonds, either, just some.
Japan negotiated a special exemption to the international capital asset ratio accords and as I recall may actually be as low as 1/2 of 1%. This was supposedly because of the "special relationship" banks had with the Ministry of Finance.
The difference between assets and capital ratio can be seen in the theoretical case of bankruptcy. A bank with $5 million paid in capital and $95m in deposits and 95 m$ in loans, whose loans for some reason decreased to a total value of $50m, would have $45m in deposit liabilities that were "uncovered." In theory--this is mainly a political issue--investors should "eat" $5m (their capital is lost in the bankruptcy) and the insurer would be pay out an additional $40m to make sure deposits were paid. In practice, some shareholders connive ways to salvage their position at the expense of the insuring entity.
. -gn.
-- Gregory P. Nowell Associate Professor Department of Political Science, Milne 100 State University of New York 135 Western Ave. Albany, New York 12222
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