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The following walk-through is meant to inform non-accountants. As such, it does not include several complex situations that could complicate some of the broad statements.
When a corporation is organized, people invest money or property in the new enterprise. In exchange for the investment, shares of ownership are issued to the investors, usually in the form of company stock. The expectation of investors—stockholders—is that the company will succeed, meaning make money, and that the value of their stock will increase.
Successful businesses generate a profit (net income) each year. The company can choose to give all or some of the profit to the investors in the form of dividends. Many corporations keep some of the profit within the company. These “retained earnings” are added to the capital investment of investors.
These two balances—outstanding stock and retained earnings—represent the equity of the corporation. Except for intangible values assessed to the corporation (such as company potential), and assuming that all other accounting balances are valued correctly, the equity of the company represents the corporation’s real value. As a result, the greater the retained earnings, the greater the value of the corporation.
A major purpose for withholding, or retaining, a portion of the yearly profit is to provide necessary cash and equity for the growth of the company. A growing company generally requires a broader base of capital on which to build its future. This capital base is increased either by issuing more stock in exchange for cash, or by the retention of some of the yearly earnings. Because an increase in the number of outstanding shares can potentially dilute the overall value of each share, the retention of earnings might be the preferred method of increasing the capital base.
When the above discussion is applied to financial corporations, capital accumulation serves not only as a base upon which future growth can be built, but more importantly, it serves as a safety net for those people who place their savings into the institution.
In the 1800’s, it was not uncommon for a bank to have an 80% capital ratio. This simply meant that before a citizen was willing to place $20.00 into the bank as a deposit, he wanted to see that the banker had placed $80.00 of his own money into the bank as capital, or seed money.
Today, the capital structure of a safe institution might be in the range of 7-10% of the total deposits. In the case of credit unions, federal law requires a 7% or greater equity position to be deemed “well-capitalized”, but sound business practices and examiner culture commonly lead to ratios in the range of 9%-12%.
What has changed? Why are capital levels so much lower now, than they were in the 1800s?
The advent of federal deposit insurance dramatically increased the confidence level of average citizens. The ultimate burden of providing safety for the savings deposits of the nation shifted from the financial institution to the federal government.
In Utah, every financial institution is insured by an agency of the federal government: credit unions by NCUSIF; banks and savings and loans by the FDIC. Both agencies work in a similar manner and offer the same degree of protection to the consumer.
One of the trade-offs that comes with federal deposit insurance is the requirement that sufficient capital be on hand, within the institutions themselves, to act as a buffer. Neither of the two government insuring agencies wants an institution to fail and then cause the agency (federal government) a loss. Therefore, annual examinations assess the strength of the institution.
From 1980 to 1995, many banks and savings and loans didn’t have sufficient capital to protect the deposits of their customers. Once an institution ran out of its own capital, demand was placed on the insuring agency to pay the remaining deposits owed to customers. The number of institutions that found themselves in this predicament was so large that the federal government had to loan approximately $300 billion to the insuring agencies of the banks and savings and loans to meet depositors’ demands.
To prevent a similar disaster in the future, the federal insuring agencies insist on an appropriate amount of capital to be held in each institution, so that no such call on government resources will be necessary in the future.
