An increase in capitalization refers to the amount of reserve assets — including cash — that an institution must maintain to lend money or invest comfortably. To be comfortable is to be able to loan or invest money without worrying about your solvency if things go badly. In other words, capitalization is about increasing the assets that support the investment capital of the company.
Increasing reserve assets for a bank or investment firm is never a good sign. Banks maintain weighted risk assets that determine, roughly, the amount of reserve capital it must have to back up these loans or investments. The Swiss standards in this regard, largely adopted worldwide, is that letters of credit and general loans are the riskiest investments for banks. Therefore, more capital is required to back these kinds of investments than others, such as interbank loans.
Confidence and Risk
Whenever confidence in the economy goes down, bank capitalization increases. This was not the case prior to the financial meltdown that started in 2007. Risky loans were disbursed without any increases in the capital required to back such loans. The riskier the proposition, the more cash the bank must have on hand to cover it in the event of default or delayed payment.
In terms of basic macroeconomic theory, when unemployment rises, property values fall and returns on investments across the board also fall, capitalization of all investments should increase. This is not a requirement in a formal sense, but it is a matter of smart investment management. In other words, it is better that fewer loans are disbursed with more capital backing them then more loans with less capital. The reason for this is that loans or other investments cannot serve as the instrument of bank insolvency if they turn sour. Hence, the international banking community has agreed upon standards that increase capitalization requirements relative to the nature of the loan or investment under review.
Depreciation is another requirement for increases in capitalization. This goes for not just banks, but for all firms investing money in the economy, especially in real estate. Risk factors naturally go down if property values are expected to increase. If this is the case, then capitalization requirements will also go down. If capitalization remains the same even when returns are expected to increase, then the economy's resources are considered to be misallocated, because the assets capitalizing the loans or investments should be active in the economy. Capitalization assets are, by their very definition, passive.
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