Bank Capital: Problems and P« R. Pierce Lumpkin The Journal of Finance, Vol. 12, No. 1. (Mar., 1957), pp. 92-93. Stable URL http: flinks.jstor-org/sici?sici=0022-1082% 28195708%2912%3A 1 %3C92%3ABCPAP3E2.0.CO%3B2-Y The Journal of Finance is currently published by American Finance Association Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at bhupulwww.jstororg/about/terms.hunl. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of « journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial us. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hutp:/ www jstor.org/joumnals/afina.html Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission, JSTOR is an independent not-for-profit organization dedicated to ereating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor.org, bupsvwwjstor.ore/ Wed Nov 1 02:12:40 2006BANK CAPITAL: PROBLEMS AND POLICIES* R, Prezce Luwexy Federal Revere Bank of Richmond ‘Tals stupy is an attempt to establish a basis for judgment by super- visory authorities of the adequacy of a bank’s capital. Numerous pro- pposals have been made in recent years based on the assumption that ‘the predominant function of bank capital is to protect depositors by being available to absorb losses. Adequacy is defined in terms of the ability to absorb losses, and measurements of adequacy rest on estima- tion of potential losses. The more recent analyses are primarily at- tempts to refine measurements of potential losses by classifying assets according to degree of risk and estimating the loss potential for each category. The sum of these loss potentials becomes the minimum amount of capital a bank should maintain. Some of the analyses sug- gest that such intangible factors as efficiency of management and eco- nomic trends should be considered as adjusting factors to the minimum capital requirements established by the loss-estimating procedure. ‘The approach of this study is to define adequacy of capital in terms of the public interest in banking. This public interest derives from the nature of the bank product—bank credit —which has attributes in law and custom both permitting and fostering its use as money. The main- tenance of bank credit as money, which is essentially the maintenance of convertibility of bank credit into legal tender money, rests on the manner in which banks are operated. Capital being one of the factors in the operation of the bank, adequacy of capital should be defined in terms of the role of capital in the principles of bank operations. The measurement of adequacy should be in terms of the contributions made by capital to the adequate maintenance of convertibility of bank credit, short and long run. Although banking is a closely supervised industry in the United States, the kinds and quantities of banking services provided are deter- mined by the decisions of private bank managements. Before any eval- uation can be made as to how much capital a bank should have, it is necessary to determine the role of capital among the factors considered by management in fulfilling the basic motivation which leads to the provision of these services. The study, therefore, reviews the principles A dissertation presented to Harvard University in 1955, 2Abstracts of Doctoral Dissertations 93 governing the operations of a commercial bank. It assumes that man- agement is motivated by enlightened profit maximization, and it secks to show how the problems in the maintenance of convertibility of bank credit (an essential ingredient of the bank product) interact with those in the maintenance of as high an average rate of return as possible on bank credit outstanding. In the light of the principles developed, the study then attempts to show the influence of capital on the decisions undertaken to achieve management's ultimate goal of long-run, maxi- mum profit. ‘The study next attempts to establish the principles governing the public supervision of a private banking system. It examines the nature of the public interest as revealed in the commercial banking processes and concludes that there are two broad aspects to this public interest: (1) the necessary employment of bank credit as a monetary instrument in carrying on the time-established patterns of economic behavior, and (2) the economic influences stemming from the issuance and retirement of purchasing power which have molded and shaped the patterns of economic activity over the past and which play an important role in the maintenance of these patterns. On the basis of these two aspects of the public interest in banking, the principles of supervision of a private- ly operated banking system are established to assute the maintenance by each individual bank of the convertibility of its credit at all times in such a manner that the bank’s ability to provide banking services adequate to prevailing economic conditions is not impaired, ‘The study then investigates the nature and effects of various govern- mental and private arrangements whose operations are imbedded in the current patterns of economic activity and whose influences are thus an integral part of the general environment in which the banks operate. ‘On the basis of the groundwork established in the principles of com- ‘mercial bank operations, the principles of supervision of a private bank- ing system, and the outside institutional factors affecting banks and the banking environment, an approach to the formulation of supervisor policies with regard to capital is suggested. The current use of capital- rating ratios by supervisory authorities is summarized. The trend to- ‘ward the use of such ratios predominantly as indicators of need for fur- ther analysis emphasizes the weaknesses in resting measurement of capital on ability to absorb assumed losses. The objective of this study is to spotlight these weaknesses and to suggest a broader approach to the bank capital problem.