MANAGING BANK CAPITAL

CHAPTER 14

Management of Financial Institutions by Dr. Meera Sharma

Capital-trade-off between safety and

growth,
Think about capital this way: It designates the
percentage of assets that a bank can stand to
lose without becoming insolvent.
A banks capital is analogous to equity. More
capital (so, less debt) means banks are more
able to withstand losses. But it also means
they cant make as much money. More capital
leading to lower returns helps explain why
banks tend to argue that holding more capital
is expensive.

Management of Financial Institutions by Dr. Meera Sharma

Ways of maintaining capital?

One is for banks to retain more of their profit, and not pay it out
as dividends or spend it on share buybacks.
Another is to sell more shares in the market. Thats generally
unappealing to banks because the shares would very likely be
sold at a discount, and the slug of new shares could dilute the
stakes of other shareholders.
Important-Reducing assets. This doesnt actually increase the
nominal level of capital. But it does increase ratio of capital to
assets, which is one way that regulators measure the adequacy
of a banks capital. If banks sell some of the things they own,
that can have the effect of bolstering capital ratios

Management of Financial Institutions by Dr. Meera Sharma

Equity-Book Value & Market Value

Subordinated debentures-bonds, ABS,
Mezzanine capital

Mezzanine financings can be structured either

as debt (typically an
unsecured and subordinated note) or preferred
stock.
Used only for operating losses not capital loss.

Reserves-cash reserves, Liquid

assets.(PROVISION AND RESERVES)
Management of Financial Institutions by Dr. Meera Sharma

Subordinated debentures-why part of

equity?

There's relatively less loss of ownership through warrants.

It's a less-expensive financing option: it costs more than senior
bank debt but less than equity.
The loan must be repaid and includes interest charges, but the
interest is tax deductible.
The company needs to provide security on the loan, perhaps
even personal guarantees.
It's unlikely there'll be management advisors, but financial
disciplines and controls may be imposed by the lender.

Management of Financial Institutions by Dr. Meera Sharma

Role of Bank Capital

Source

of Fund and Investment for

Growth
Capital Requirement-8%
Loss Provisions

Management of Financial Institutions by Dr. Meera Sharma

ECONOMIC CAPITAL

Different Definitions of Capital

-

Book value of capital,

Market value of capital,

Regulatory capital-8% or

Economic capital

Management of Financial Institutions by Dr. Meera Sharma

ECONOMIC CAPITAL

Economic Capital
Haubenstock and Morisano (2000) define
economic capital as the
aggregate amount of equity capital required
as a cushion for a companys unexpected
losses due to all its credit, market and
operational risks.
Can a bank provide for all its unexpected
losses?
Management of Financial Institutions by Dr. Meera Sharma

ECONOMIC CAPITAL

Economic Capital

The difference between unexpected losses and

expected loses is the amount of economic capital
required by an institution.
Expected losses are covered by the cumulative amount of
charges made to the profit and loss account through
provisions, these could be on account of specific loan losses
or expected losses owing to market or operational risks. Ex.
Expect NPA t grow at 2-3%

The level of unexpected losses to be covered and therefore,

the amount of economic capital to be maintained is a
managerial decision.

Management of Financial Institutions by Dr. Meera Sharma

ECONOMIC CAPITAL

Economic Capital

Deciding on the amount of economic capital is

similar to the choice of a confidence level during
risk measurement.

The higher the confidence level chosen by a bank,

greater is the amount of economic capital required
and higher is the perception of safety that
stakeholders have about the bank.

Now we know why economic capital is also

called capital-at-risk!
Management of Financial Institutions by Dr. Meera Sharma

ECONOMIC CAPITAL

Economic Capital

Capital-at-risk is specified over a time horizon

and a confidence level.

A horizon of one year and a confidence

level of 99% imply that the capital-atrisk is that amount of capital which is
likely to be wiped out by losses over a
year only 1% of the time.
Management of Financial Institutions by Dr. Meera Sharma

Shareholder Value Added(SVA)

Shareholders view point is different than regulators points. They seek
an optimal mix of debt and equity finance to maximize the value of
their common stock. They focused more on the expected value of
rates of return on equity and variability.
Major factors affect capital structure decision of bank shareholders.
1. Financial risk and share valuation-deposit insurance
2. Corporate control
3. Market timing-cyclical price movement in debt and equity market
4. Asset Investment consideration-limit in lending
5. Dividend policy-immediate returns and long term gains
6. Debt Capacity-some funds must be used for investment
7. Transaction costs-equity expensive for banks
8. Internal Expansion- for high capital requirement instead of
borrowed funds
Management of Financial Institutions by Dr. Meera Sharma

Shareholder Value Added(SVA)

Risk Adjusted Net Income is also called

Economic Profit
Economic Profit = Net Earnings Interest
Payments Operating expenses- Specific Loan
loss provisions Taxes capital charges
Capital Charge = Economic Capital allocated
* Hurdle Rate

Management of Financial Institutions by Dr. Meera Sharma

Trends of Bank Capital

In July, 2014:Bank of India raises Rs 1,250 crore via perpetual Tier-I

bonds. "This (bond issue) will help us improve our capital adequacy
ratio by 60 bps," V R Iyer, chairperson and managing director of the
bank, told ET. "Issue amount of Rs 1,250 crore was fully subscribed on
the first day
The larger issue is the capital need of Indian banks. The government
has made a budgetary provision of Rs.14,000 crore in the current fiscal
year to recapitalize public-sector banks.
The latest equity issue of State Bank of India made it abundantly clear
that there are not too many takers for Indian banks equity. LIC bought
41.3% of the total shares that State Bank sold on 29 January as part of
its qualified institutional placement offering.
Currently, government stake in public sector banks varies between
88.93% (in Central Bank of India) and 58.9% (in Allahabad Bank).
Under norms, the government stake cannot fall below 51% in these
banks.

Management of Financial Institutions by Dr. Meera Sharma