ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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How Much Capital Does a Bank Need?

Most companies would think twice before operating at a debt to equity ratio (or leverage) of 2:1. Some capital-intensive businesses, such as shipping, opt for a ratio that is considered outlandish say, 5:1. But banks really take the cake. A leverage of 25:1 is not uncommon in banking. During the fi nancial crisis, there were large banks and investment banks that operated at ratios of 40:1 or more.

Such levels of leverage render banks fragile. Since banks are interconnected to a high degree through the payments system and in other ways, the fragility of an individual bank can translate into fragility of the entire banking system, especially if the bank happens to be large. The collapse of banks carries enormous externalities, so banks are not easily allowed to fail. They are supported through insurance guarantees, central bank lender-of-last-resort facilities and the like and when they do fail, they are bailed out by taxpayers.

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