Bank Capital and Liquidity

Marc Farag, Damian Harland and Dan Nixon

Bank capital, and a bank’s liquidity position, are concepts that are central to understanding what banks do, the risks they take and how best those risks should be mitigated both by banks themselves and by prudential regulators. As the 2007–9 financial crisis powerfully demonstrated, the instability that can result from banks having insufficient financial resources – capital or liquidity – can acutely undermine the vital economic functions they perform.

This chapter is split into three sections. The first section introduces the traditional business model for banks of taking deposits and making loans. The second section explains the key concepts necessary to understand bank capital and liquidity. This is intended as a primer on these topics: while some references are made to the 2007–9 financial crisis, the aim is to provide a general framework for thinking about bank capital and liquidity. For example, the chapter describes how it can be misleading to think of capital as “held” or “set aside” by banks; capital is not an asset. Rather, it is a form of funding: one that can absorb losses that could otherwise threaten a bank’s solvency. Meanwhile, liquidity problems arise due to