Introduction to Finance

DISCUSSION QUESTION 3
In your opinion, should bank managers be allowed to seek high profi tability by taking on 
high risk and low safety?
Capital Management
Adequate capital is necessary to ensure that banks remain solvent, meet depositor demands, 
and pay their debts as they come due. A bank is considered solvent as long as its assets are 
worth more than its liabilities. Let’s return to Figure 3.5. Since we know that total assets must 
equal total liabilities plus stockholders’ equity, the diff erence between total assets and total 
liabilities refl ects the degree of solvency. 
What can cause a bank to become insolvent? One reason is that excessive credit risk could 
result in nonrepayment of loans. For example, if businesses default on the loans they owe to a bank, 
that bank’s assets will decline by the amount of the defaults. If a bank’s assets decline enough relat-
ive to its liabilities, the bank could become insolvent. In addition to credit risk reasons, a bank may 
become insolvent because of 
interest rate risk
, which is the risk associated with changing market 
interest rates on the value of underlying debt instruments.
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For example, let’s assume that a bank 
purchases $100 million of long-term U.S. government bonds when interest rates are 6 percent. If 
interest rates rise, the value of the bonds held as assets will decline. If the decline in the bond value 
causes the bank’s assets to be less than its liabilities, the bank would be insolvent.
Adequate bank capital represents an important cushion against both credit risk and interest 
rate risk as they aff ect bank solvency. Bank regulators set minimum capital ratio requirements 
for the banks and other depository institutions that they regulate. A basic common equity cap-
ital ratio is defi ned as a bank’s common equity divided by total assets.
Common equity capital ratio =
Common equity
Total assets
× 100 (3.3)
The common equity capital ratio for a bank with common equity of $3 million and total assets 
of $50 million would be,
Common equity capital ratio = $3 million/$50 million = 6%
Other capital ratios are now in use by bank regulators. Adjustments often are made to exclude 
intangible assets such as goodwill, which is created in mergers and acquisitions. A broader view 
of capital also is often used. In addition to noncumulative preferred stock, banks sometimes issue