Capital Requirement

You require capital to do anything. We all do...at least all of us who live as a participant in a modern society, with things like mortgages, car loans, college tuition payments and Frappuccinos. We also need to keep a cushion of a few months' worth of salary just in case the car breaks down, the roof falls in or you learn you have scabies.

Banks also have capital requirements. The need money to make loans and have cash available in case customers want to withdraw their savings. Since there have been bad experiences in the past (banks failing during the Depression of the 1930s, the Great Recession in 2008 and the Savings and Loan crisis of the 1980s, just to name a few) banks are also required to keep a cushion.

Also known as regulatory capital, banks must have a certain amount of "liquid capital" (able to be spent immediately) according to the level of assets they own. The Federal Deposit Insurance Corporation and the Federal Reserve, as well as state banking regulators, set these requirements and regularly audit banks to check their capital level.

The capital requirement for banks is based on the "weighted risk" of each type of asset the bank owns. If they are making a lot of real estate loans with very little in terms of down payments by their customers, that is going to be weighted heavily. Or perhaps the bank has made a lot of business loans with very little collateral given by the borrower. A requirement might state that for every dollar of residential loan made, the bank must hold nine cents of capital. For a safer loan with lots of collateral, it might be 5 cents for every dollar of loan.