How does the core capital of a bank protect insolvency?

The volatility of incoming and outgoing transactions for all its account holders and other customers, make it difficult, if not impossible, for financial institutions and banks in particular, to not open and close their balance every single day. Confidence in the monetary system and its overall public acceptance allow banks to maintain several mismatches in their books. Such systems only work when capital and liquidity is secured. In traditional economic theory, the central bank acts as a lender of last resort to provide liquidity to the system when needed. However, its applicability is excluded for insolvent banks and financial institutions. This insolvency is determined by the stability of the capital of the bank. Such bank capital is divided between Tier 1 Capital and Tier 2 Capital.

In a simplified setting, financial institutions are commercial enterprises. They take deposits from investors and lend these deposits out to borrowers. Banks therewith borrow short and lend long. To accelerate this process, financial institutions use a variety of ways to leverage their lending potential. The process where financial institutions are allowed to provide unsecured credit to borrowers is called fractional reserve lending. A financial meltdown can therefore trigger a highly contagious and systemic response. This became a serious treat during the global financial crisis where the failure of Lehman Brothers resulted in an international domino effect that brought financial institutions and countries in severe difficulties.

Bank regulators use early intervention techniques to avoid that insolvency leads to bank liquidation and loss of customer money. As such, several measures are implemented to protect and maintain the stability of the financial system. However, rescue missions should not trigger moral hazard and are not a substitute for excessive risk taking. Bad examples as experienced in Cyprus during the European sovereign debt crisis where a full country was sucked into the failure of one of its local banks, make intervention and resolution needed. In the matter of the Bahamas based Lucayas Bank, such early intervention has proven to be necessary to protect creditors interest. The bank is a non-resident financial institution, and even though they hold a local Bank and Trust License, there is no participation in the domestic deposit guarantee scheme. As such, customer deposits and investments are at risk.

By maintaining a stable and adequate capital position, financial institution can absorb financial shocks. Bank capital is distinguished by three tiers that include core, supplementary and tertiary capital. Tier 1 contains shareholder capital and retained earnings; tier 2 includes the long term borrowing, reserves, provisions, and subordinated bank debt; while the short term subordinated loans are covered under tier 3 capital. The financial health of supervised banks is controlled by these capital ratios, where assets are not treated the same and include a risk-weighting formula to avoid undesired surprises.

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