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.
Related or Semi-related Video
Finance: What Does "Capital Intensive" M...26 Views
Finance a la shmoop what does capital-intensive mean? lots and lots and
lots and lots of capital yeah that's what it means starting a website, two [Two young kids setting up a website in a garage]
kids a garage and a nice home computer not capital intensive, drilling for oil
in the North Sea highly capital intensive...
well capital needed for the two kids in a garage building a search engine about
two million bucks capital needed for the oil rig well like ten billion bucks and
why does the capital intensity matter well if you can create Google that
generates a few billion dollars of free cash flow a quarter for a total capital
input of maybe a hundred million dollars ie a few rounds after the garage round [Equity investment agreement documents appear]
then investors in it make an absolute killing like if you don't dilute
yourselves and the stock goes up a lot life's good yeah hundreds or thousands
of times their original investment if you create BP British Petroleum or Royal
Dutch Shell or Chevron which also have a few billion dollars of free cash flow a [Cash flowing into fuel tanks]
quarter but it takes you ten billion dollars in capital to generate those
returns then yes you get a nice investment return but it's nothing that
you know Vikings sing songs about and it's the allure of the capital [Man typing on laptop]
unintensive businesses like building a website in Yahoo or a search engine in Google or a video streaming
site in Netflix that takes relatively small amounts of capital to start and
then produces mounds of free cash profits that has made venture
capitalists fall all over themselves hoping to find that one little garage [Person looking through binoculars at garages]
with the next great white whale yeah that's intensive...
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