# Why do banks have capital requirements on deposits?

In article from Reuters: Big U.S. banks hunger for loans, capital relief as deposits pile up, we read:

Combined with rules that require more capital for bigger balance sheets, that makes deposits more expensive to hold, instead of profitable.

If I understand correctly, it means that the banks has to keep capital against the deposit. On first sight, it seem quiet strange to me: since deposits are basically cash, and not a risk loan that the bank should be required to hold capital. So why is that?

• think about what happens when the person you have given loan to defaults? The capital requirement against the deposit would help you return the money to your depositor. – nimbus3000 Feb 4 at 11:17
• @nimbus3000, Thanks. but doesn't a loan also require capital? I mean there are already capital requirement for loans, why should we add also to deposits (which is basically the bank receiving cash) – d_e Feb 4 at 11:22
• Filing this as evidence for the idea that interest rates need to be negative: if they were lower, there would be fewer deposits and less of what the article calls "excess liquidity". – pjc50 Feb 5 at 9:38
• @pjc50 filing that as evidence you want to abolish cash – user253751 Feb 5 at 14:10

When someone deposits money at the bank, it immediately appears on the balance sheet as both, an Asset and a Liability: on the liability side, it will sit as something along the lines of "deposit owned to customers", and on the Asset side as "cash" (this is just regular "double entry accounting").

If the bank then lends part of this deposit as a loan or mortgage, it will generate some income on this deposit. The deposit will still be sitting on the balance sheet as a Liability ("deposit owned to customers"), but on the Asset side the "cash" item will have turned into "Mortgage due from customers" or "Loan due from customers".

The bank's balance sheet grows the same second when the deposit enters the bank and the bank will need to allocate capital against the size of the balance sheet. The difference is that when the deposit sits on the Asset side just as "cash" it generates no income for the bank, whilst the bank has to pay interest to the customer + allocate capital. But when the bank manages to "transform" the asset from cash into a loan or a mortgage, it will generate some income (and it will thereby justify allocating capital against it, i.e. it will put the capital "to work").

Ps: that's why the headline of the article you reference is:

"Big U.S. banks hunger for loans, capital relief as deposits pile up"

I.e. they feel the need to turn that "cash" item on the asset side of their balance sheet into a "loan" item, but the demand for loans is not there right now (so they also plead for at least some capital relief on those deposits, at least until loan demand picks up again).

• Thanks it is much clearer now. I understand the banks motivation. only one thing I seem to be missing. "will need to allocate capital against the size of the balance sheet." : As far as I know capital allocations does not depend on the value of the balance sheet per se, but depends on the assets in the balance. i.e. safe loan will require less capital than riskier one. I fail to understand why to impose capital requirements on "cash" asset? – d_e Feb 4 at 11:43
• @d_e: good point, capital requirement depends on Risk-Weighted assets, and these in turn depend on the type of asset. I am not 100% sure if "cash" attracts any capital charge, but even if it's small, it is "annoying" for the bank because it will reduce the "return on capital" that the bank will generate. Also, banks worry about their leverage ratio (i.e. Assets / Capital), and this goes up even if capital requirement doesn't. – Jan Stuller Feb 4 at 11:46
• @d_e: I edited your question, because I am myself curious if anyone knows the answer to whether cash attracts capital charge. Pls feel free to un-mark my answer so that the question attracts more responses. – Jan Stuller Feb 4 at 11:49
• "cash" is not really valid (if not physical). All digital cash is ultimately traced back to the central bank authority. So "digital cash asset" would be converted to another asset, e.g. "central bank deposit", "government debt", "mortage", "corporate debt" etc. The first of those has a risk weight of 0%, and likely as does 2nd. That potentially leaves capital (from a capital ratio) perspective unimpacted by a deposit. – Attack68 Feb 4 at 22:38
• @d_e yes they are forced to do that. typically what they do though is deposit the cash with another bank who does have access to the FED, or they buy a T-Bill, or they transact a reverse repo. – Attack68 Feb 5 at 16:59

This is an answer from European perspective.

As @JanStuller has explained a retail cash deposit results in two balance sheet entries.

In the simplest form:

(Liability) Customer Demand Deposit, e.g. €100
(Asset) Central Bank Deposit, e.g. €100

### Capital Requirements

The asset can be transformed to other forms but according to Capital Requirements Regulation Article 114 a cash deposit with the ECB has a risk weight of 0%. Therefore no additional capital is required to be held against this customer deposit on this measure.

$$\text{new ratio} = \frac{\text{old capital}}{\text{old risk weighted assets + 0% x €100}}$$

### Liquidity Coverage Ratio

Article 412 essentially states that liquid assets must cover outflows minus inflows over the next 30 days. Again the asset form is important but here 100% of the central bank deposit is counted, but the liability is only counted from 5% to 10%, as retail deposits are generally considered sticky Article 421 so there is a 'run-off' rate. This impacts the ratio favourably.

$$\text{new ratio} = \frac{\text{old HQLA + 100% x €100}}{\text{old net outflows + 95% x €100}}$$

### Net Stable Funding Ratio

This basically says that the available stable funding (ASF) exceeds the required stable funding. Basel states that demand deposits qualify for 90-95% ASF while central bank deposits amount to no RSF, so here again the ratio is impacted favourably.

$$\text{new ratio} = \frac{\text{old ASF + 95% x €100}}{\text{old RSF outflows + 0% x €100}}$$

### Leverage Ratio

This is a banks Tier 1 capital divided by total exposure. The exposure of a central bank deposit is zero (I believe) Article 11. Therefore in this scenario the ratio is unchanged.

$$\text{new ratio} = \frac{\text{old capital}}{\text{old risk exposure + 0% x €100}}$$

### Net Interest Income

The profit for the bank here is the interest rate differential between the central bank deposit and the retail deposit account. In Europe this is problematic since the central bank rate is lower than 0%.

### Other factors

When that asset is not a central bank deposit it clearly impacts the above calculations. On top of that there may well be additional capital charges for market risk, i.e. if you buy a long dated treasury bond instead of T-bill.

• That's a great answer. +1 – Jan Stuller Feb 5 at 7:32

Afaik and as Jan Stuller already mentioned, banks have to meet requirements to the Leverage Ratio, which gets mandatory with CRR II in 2021. For simplicity, most banks will have to meet a minimum of 3%.

Important note: riskweights do not play a role here.

That's why the leverage ratio is decreasing when customers put their money to the banks, leading to banks will need to increase the numerator (=capital) to increase their Leverage Ratio. (But since demand for loans is low and cash or "riskless" bonds don't earn money, how should banks increase their capital...)

• "Important note: riskweights do not play a role here." => do I understand your post correctly that cash would attract zero risk weights and therefore zero capital consumption, but it is only the leverage ratio that drives the need to increase capital? – Jan Stuller Feb 4 at 13:39
• Indeed, LR is an indicator that doesn't take riskweights into account. – simzoor Feb 4 at 13:50
• Understood. But just to be sure: are you absolutely certain that cash doesn't attract any Risk Weighted Assets? (intuitively it shouldn't, because it is the "safest" asset... so it'd make sense) – Jan Stuller Feb 4 at 13:54
• To be a bit more clear: I'm assuming cash as the money that banks have on their account of the related central bank for payments (ECB, Bundesbank, Banque de France etc.). It is a bit more tricky with "cash equivalents" (e.g. nostro accounts with other "normal" banks won't get a RW of 0%, but 20%). eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2015_2001 – simzoor Feb 4 at 14:23
• Excellent, thank you!! – Jan Stuller Feb 4 at 14:34

Another problem is the bank's GSIB score. There are about 10 components that go into the GSIB score calculation, but one of them is (bank equity)/(balance sheet).

Having a poor GSIB score means the bank will have to a surcharge assessment on it's balances.

So in other words, if a bank just takes in more deposits - and does nothing with them - the leverage ratio will not change. But the GSIB score increases. Of course, a rational person would say, "who cares?" as this is just cash vs balances. But the rules are the rules and they will now need even more capital set aside.

It's important to understand that the GSIB scores are a step function. So, a bank will have so far that it can go until hit hits a new tier and then all balances are subject to a higher assesment.

• +1 from me for the GSIB score (of which I was unaware). But I don't think the following statement of yours is correct: So in other words, if a bank just takes in more deposits - and does nothing with them - the leverage ration will not change. The leverage ratio will increase if a bank takes in more deposits, because its balance sheet grows, but its capital (i.e. equity) does not grow. You cannot count "cash" from the Asset part of a balance sheet into the Equity part of a balance sheet. Equity only grows via retained earnings or rights issues. – Jan Stuller Feb 4 at 15:57
• There are quite a few ratios under Basel. I'm not an expert on the terminology. I think just a balance that sits in the Fed vs the customer deposit is OK. The problem is the capital ratio. (Not enough bank equity vs the balance sheet). I know in the money market research that I get sometimes it's all about the GSIB limit for the new balances. That worry dwarfs worries about other items. (Because of the step function nature as well) – JoshK Feb 4 at 16:01

Apologies if this answer is a bit off the beaten track.

The reason capital requirements are imposed on deposits is historical. In the United States they were introduced by Alexander Hamilton (1755-1804) who was knowledgeable about British banking practices.

In the 18th century people understood that banking can be dangerous. The failure of Law's Bank in France in 1720 is an extreme example of what can go wrong with completely unregulated banking. It seemed sensible that, to reassure depositors, there should be a requirement that at least X% of the amount you deposit should be set aside in some kind of "reserve".

People such as Hamilton understood that the need for such reserve requirements is not only prudential (for the benefit of depositors) but even more importantly for macro-financial reasons (for the stability of the banking system, to avoid an infinite expansion of the money supply).

The reason deposit reserve requirements exist today (where they do exist) is mainly traditional. As other answers show, nowadays there are many other tools used to regulate the banking system (LCR, leverage ratios, etc. etc.). But reserve requirements were the standard way for over 200 years.

• Great insights, didn't know many of these facts! Learned something new. Just to stress a point: deposit reserves are a separate measure to capital allocation (I am sure you know, just wanted to highlight it). Even if % of deposits needs to be "reserved" as cash and cannot be re-loaned, these reserves will still sit on a balance sheet as an "Asset", they won't increase the Capital part of the balance sheet. – Jan Stuller Feb 4 at 20:15
• There has been more bank runs in regulated than irregulated markets. Compare Scotland (irregulated) with England (regulated) during 18th-19th century or US (regulated) with Canada (irregulated) during the same period. – d-b Feb 5 at 8:59

Bank reserves are based on liabilities because that is the money people expect to be able to get back whenever they want it.

If I put money into a brokerage account and direct my bank to "Buy GameStop!" with it and the GameStop tanks, well that is too bad for me.

If I put my money into a savings account (loan my money to the bank) and my bank buys GameStop and GameStop tanks, I can still get my money back, and too bad for the bank.

So the bank needs to have some money liquid (in reserve) so that they still have money for me even if their investments do poorly (they don't keep the whole amount in a vault, but a percentage).

On top of that, the article seems to specifically be talking about the globally significant banking institution (GSIB) surcharge. The GSIB surcharge was created after the 2008 financial crisis based on the idea that some banks have become so interconnected and large that if they failed it would be catastrophic for the entire financial system.

One of the calculations that goes into GSIB is "assets under trust"--basically a complicated way of saying how large the bank is. Larger banks are required to be more careful (keep more money in reserve) than smaller banks.

• there is a technical difference between 'own funds = T1 + T2 capital' and 'reserve requirements'. It might be easy to meet reserve requirements by borrowing money in capital markets and posting a necessary amount to the central bank, but own funds cannot be as engineered therefore regulation is structured around capital ratio and leverage ratio. – Attack68 Feb 4 at 23:37