Explain Tier 1 capital ratio
Hi, I find this forum to be the most relevant one for this question; it's a rookie question:
I know that bank must maintain minimum Tier 1 capital ratio of 8% (T1 vs risk-weighted assets). And it is this ratio (and not deposits) that is usually the upper limit to how many assets the bank can hold.
But what happens if the bank only wants to hold 0% risk-weighted assets like US treasury bonds? Does T1 capital ratio become irrelevant and now it's just the deposits that set the upper limit?
Examples:
If Tier 1 is $1B and the bank has $1T of deposits, and the bank wants to hold only 100% risk-weighted assets, the bank can hold max ~$10B of those assets but,
if Tier 1 is $1B and the bank has $1T of deposits, and the bank wants to hold only US treasury bonds which are 0% risk-weighted, the bank can hold up to ~$1T of those bonds.
I'm I getting this right?
If you’re only looking at Tier 1 ratio, I guess your scenario theoretically checks out. The issue with your scenario is there are other capital ratios, specifically the Tier 1 Leverage ratio in this case, that would constrain you. A bank with ~$1B of Tier 1 capital would only be able to hold ~$20B of assets to be well capitalized with a 5% Tier 1 Leverage ratio. So regardless if they were planning to only invest in 0% risk-weighted assets, or even just hold cash, they wouldn’t be able to take on ~$1T of deposits to begin with.
Oh ok, never hear of the leverage ratio.
So what happens if a new bank opens with low T1 but there is an enormous interest and people want to deposit money? The bank would need to turn new customers away after deposits reaching $20B and the increase of deposits from that point on would be conditional upon retained earnings from the return on those $20B assets rather than market demand? That would mean that the only way to grow the bank in this circumstance is for the bank to somehow raise equity and increase T1. There is no other way, right?
Correct, the bank would have to turn away deposits (or they could lower interest rates on any deposit offerings which would likely reduce demand to put deposits at that bank) until they could grow equity through retained earnings or an equity offering. A de novo bank receiving such an extreme demand for incoming deposits is highly unlikely/unusual day 1. You will see de novo banks having to raise equity regularly over a few years when they start to alleviate this issue if they are growing consistently but aren’t profitable enough yet to grow equity through retained earnings.
Ok, I'm reading about T1 leverage ratio and I'm confused. It says it "measures a bank's core capital relative to its total assets." As far as I understand deposits are not considered assets (but rather liabilities). So why/on what basis are deposits limited by T1?
(and how frustrating that i cant find any proper resource on the web on basics of how banks operate. unbelievable.)
Goes back to basic accounting of assets = liabilities + equity. Since your assets are constrained by your equity, your maximum liabilities (or deposits) is a function of assets less liabilities. Looking back at the scenario earlier, if you have $1B in equity and are at the maximum of $20B of assets, liabilities will be $19B.
You can sweep some off balance sheet, change the yield on deposits to attract less deposits etc. If the incoming deposits are truly sticky, it would be very easy to raise equity.
Piggybacking off this - IF there was such a large demand to put deposits at this specific bank, could be an opportunity to raise equity from some of the larger depositors so interested in this particular bank.
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