Bank Reserves and Capital Requirements

How rules on bank capital and reserves protect depositors and the financial system, including the international Basel standards.

Banks lend out most of the money deposited with them. If many loans go bad, a bank could fail, harming depositors and possibly the wider economy. Regulators therefore set rules on how banks fund themselves and how much they keep in safe forms.

Capital requirements

A bank’s capital is the money provided by its owners, plus retained profits. It acts as a cushion: if loans go bad, losses are absorbed first by capital before depositors are affected.

Capital requirements set a minimum amount of capital relative to a bank’s assets, weighted by risk. Riskier loans require more capital. The international standards are set by the Basel Committee on Banking Supervision. After the 2008 financial crisis, the Basel III standards raised the quantity and quality of capital banks must hold.

Reserve requirements

Reserve requirements require banks to keep a share of deposits as reserves, either as cash or at the central bank. In India, the Cash Reserve Ratio, or CRR, requires banks to keep a percentage of deposits with the Reserve Bank of India. The Statutory Liquidity Ratio, or SLR, requires them to hold a share in safe assets, such as government securities.

Some countries, including the United States since 2020, have set reserve requirements to zero, relying instead on capital and liquidity rules.

Liquidity rules

Basel III also introduced liquidity rules, requiring banks to hold enough easily sold assets to survive a period of heavy withdrawals.

The capital cushion

A bank has 100 crore rupees of loans funded by 90 crore rupees of deposits and 10 crore rupees of capital. If 5 crore rupees of loans go bad, capital falls to 5 crore rupees, but depositors are still fully protected. If the bank had only 3 crore rupees of capital, the same losses would leave it unable to repay depositors in full.

The trade-off

Higher capital makes banks safer, but some argue it raises lending costs and reduces credit. Research by the Bank for International Settlements and others suggests that moderately higher capital brings net benefits by reducing the likelihood and cost of crises.

Thinking capital is money banks keep in a vault

Capital is not cash set aside; it is the part of a bank's funding that comes from owners rather than borrowing. It determines how much loss a bank can absorb, not how much cash it holds.

Key takeaways

Bank capital is owners' funding that absorbs losses before depositors are affected.
Basel III raised capital and liquidity standards after 2008.
India uses the Cash Reserve Ratio and Statutory Liquidity Ratio.
Higher capital makes banks safer and, on balance, reduces the cost of crises.