Banks hold capital because they are required to do so by regulatory authorities. Because of the high costs of holding capital for the reasons just described, bank managers often want to hold less bank capital relative to assets than is required by the regulatory authorities. In this case, the amount of bank capital is determined by the bank capital requirements.
Suppose that as the manager of the First National Bank, you have to make decisions about the appropriate amount of bank capital. Looking at the balance sheet of the bank, which like the High Capital Bank has a ratio of bank capital to assets of 10% ($10 million of capital and $100 million of assets), you are concerned that the large amount of bank capital is causing the return on equity to be too low. You conclude that the bank has a capital surplus and should increase the equity multiplier to increase the return on equity. What should you do?
To lower the amount of capital relative to assets and raise the equity multiplier, you can do any of three things: (1) You can reduce the amount of bank capital by buying back some of the bank’s stock. (2) You can reduce the bank’s capital by paying out higher dividends to its stockholders, thereby reducing the bank’s retained earnings. (3) You can keep bank capital constant but increase the bank’s assets by acquiring new funds—say, by issuing CDs and then seeking out loan business or purchasing more securities with these new funds. Because you think that it would enhance your position with the stockholders, you decide to pursue the second alternative and raise the dividend on the First National Bank stock.
Now suppose that the First National Bank is in a similar situation to the Low Capital Bank and has a ratio of bank capital to assets of 4%. You now worry that the bank is short on capital relative to assets because it does not have a sufficient cushion to prevent bank failure. To raise the amount of capital relative to assets, you now have the following three choices: (1) You can raise capital for the bank by having it issue equity (common stock). (2) You can raise capital by reducing the bank’s dividends to shareholders, thereby increasing retained earnings that it can put into its capital account. (3) You can keep capital at the same level but reduce the bank’s assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities. Suppose that raising bank capital is not easy to do at the current time because capital markets are tight or because shareholders will protest if their dividends are cut. Then you might have to choose the third alternative and decide to shrink the size of the bank.
In past years, many banks experienced capital shortfalls and had to restrict asset growth, as you might have to do if the First National Bank were short of capital. The important consequences of this for the credit markets are discussed in the application that follows.