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CAPITAL TPYES

CAPITAL DEFINITIONS

Accounting capital, economic capital, and regulatory capital are distinct concepts used in the financial industry to assess and manage a company's capital.

1.    Accounting Capital: Accounting capital is the capital amount reported in financial statements, representing a company's equity or net worth. It is calculated by deducting liabilities from assets and provides a snapshot of the company's financial position at a specific time. While used for financial reporting, it may not fully capture the institution's economic or risk profile.

2.    Economic Capital: Economic capital is the capital needed to support a company's risk profile and potential losses. It accounts for various risks, like credit, market, operational, and liquidity risks. Calculated using sophisticated models, it helps determine the appropriate capitalisation level for financial health and resilience.

3.    Regulatory Capital: Regulatory capital is the minimum requirement set by authorities for financial institutions to ensure stability and protect depositors and investors. Basel III is a well-known framework that sets guidelines for capital adequacy and risk management. Different tiers of capital, like Tier 1 and Tier 2, have specific criteria and usage restrictions. Financial institutions must maintain regulatory capital above the minimum threshold to comply with guidelines.

In summary, accounting capital represents equity or net worth in financial statements. Economic capital covers risks and losses based on the company's risk profile. Regulatory capital is the minimum requirement for financial stability and safety set by authorities.

CAPITAL FUNCTIONS FOR BANKS & FINANCIAL FIRMS

In banks and financial firms, capital is the financial resources supporting operations and absorbing potential losses. It represents long-term funds contributed by owners or investors, acting as a cushion to protect the institution from financial distress.

There are generally two types of capital:

  1. Equity Capital: Represents ownership interest contributed by shareholders, including common and preferred stock. It provides a buffer against losses and funds growth opportunities, with shareholders expecting dividends and capital appreciation.

  2. Debt Capital: Refers to funds borrowed through debt instruments like bonds, loans, or lines of credit. It is a liability requiring repayment with interest. Debt capital allows leveraging operations beyond equity capital but adds financial obligations and interest expenses to the balance sheet.

 

The uses of capital in banks and financial firms can be classified into several categories:

  1. Regulatory Capital: Financial institutions must maintain minimum capital levels to comply with regulations, protect depositors, and mitigate systemic risks. It is classified into tiers (Tier 1 and Tier 2) with specific criteria.

  2. Liquidity Management: Capital is vital for meeting short-term financial obligations, providing loans, honoring withdrawals, and ensuring smooth operations without liquidity shortages.

  3. Risk Management: Capital is allocated to manage credit, market, operational, and liquidity risks, absorbing potential losses from various events.

  4. Business Expansion: Capital funds growth initiatives like new branches, products, markets, or acquisitions, enhancing market share and profitability.

  5. Dividend Payments: Profits may be distributed as dividends to shareholders, requiring adequate capital for ongoing operations and growth.

 

It's important to note that the specific uses of capital may vary among financial firms depending on their business models, regulatory requirements, risk appetite, and strategic objectives.

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