Why do banks have capital requirements on deposits?

Question

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?

Answer 1

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).

Answer 2

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.

Answer 3

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...)

Answer 4

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.

Answer 5

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.

Answer 6

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.