The attribution of capital to foreign banking permanent establishments in the UK: What is capital for a bank and what does it do with it?
All companies require capital to support their activities, for example to acquire premises and machinery to enable them to manufacture products. Such capital might be raised as equity capital by issuing ordinary shares or as loan capital by the issue of bonds.
Banks are exceptional because they trade in money, rather than goods in return for money. As a result, as well as needing funds for capital purposes, they rely on access to funds in the form of money as an integral part of their trading activities. Banks do, of course, also offer fee-earning services such as merger and acquisition services, but at its simplest they make a profit by borrowing money at interest from third parties and lending it to others at higher rates of interest. That money comes both from investors and customers who place funds with the banks.
To protect the interests of customers, banks throughout the world are subject to regulatory standards designed to make sure they have a solid base of capital available at all times to meet their customers’ demands. That capital requirement needs to be sufficient to act as a buffer against future, unidentified, even quite improbable losses, while still leaving a bank room to recover or to organise an orderly winding down of its business.
The level and type of capital of banks (and certain other financial institutions) is, therefore, prescribed in a way that the capital of other concerns is not. For UK regulated banks this involves agreement, on an individual basis, between the bank and the Financial Services Authority (FSA), of a Capital Adequacy Requirement (CAR, sometimes known as CAD because they are derived from EU directives), which is the minimum level of capital they must hold. The CAR is an appropriate ratio of capital to risk-weighted assets, depending on the size of the bank, the nature of its activities and any other factors which are considered relevant. It can be met by holding various types of capital, which are termed Tier 1, Tier 2 and Tier 3. How this equates to “equity capital” and “loan capital” is dealt with in INTM267762, but generally Tier 1 capital is equity capital and Tier 2 and Tier 3 capital is loan capital.
In practice, banks normally hold capital in excess of that required by the regulator. They may exceed their CAR to allow themselves a regulatory ‘cushion’ or they may have other commercial reasons for choosing to hold more than the regulatory minimum. Under the FSA’s regulations banks are allowed to hold an amount of Tier 2 capital up to, but not exceeding, their Tier 1 capital. However banks normally hold more Tier 1 and less Tier 2 than the FSA allows. Thus, even though the FSA may allow a bank’s loan capital to comprise half its total regulatory capital, in practice the proportion of loan to equity within the regulatory capital is usually much lower.