How Have Banks Managed Their Capital – A Ratio Decomposition Analysis Abstract This paper is motivated by the conflicting evidence in prior bank capital structure literature and the lack of resilience of bank capital to the current financial crisis of 2007-2010. The paper analyzes the reaction of banks’ asset portfolio and capital structure to adverse changes of regulatory capital ratios. Based on management discretionary decisions pertaining to balance sheet items, I question whether banks respond to declines in tier 1 and total regulatory capital ratio through gaming the leverage ratio or though the risk-weighted assets. The paper employs a ratio decomposition approach, where the regulatory ratio is broken down to its components of leverage along with detailed positions in various risk-weighted asset classes. I also examine whether asset risk weighting is effective in measuring the degree of bank riskiness. Therefore, I test whether response of bank managers to declines in regulatory capital changes through risk-weighted assets is associated with other measures of risk. Finally, I conjecture that managers use discretion to manage regulatory capital through changes of asset positions and classification to relevant risk classes. 1. Background and Motivation Looking at the contradictory results of prior research on bank capital structure, banks seem to face conflicting goals emanating from shareholders, debt holders and regulators (Gropp and Heider, 2009). Shareholders aim at maximizing the return on the equity invested. Therefore, they implicitly get along with as small equity capital as feasible to achieve their objective. Debt holders have different goals to minimize the riskiness of assets as opposed to raising new e... ... middle of paper ... ...erican Economic Review, 48 (3), 261-297. Moyer, S. (1990) “Capital Adequacy Ratio Regulations and Accounting Choices in Commercial Banks”, Journal of Accounting and Economics, 13 (2), 123-154. Myers, and Majluf, (1984) “Corporate Financing and Investment Decisions When Firms Have Information That Investors Donot Have”, Journal of Financial Economics, 13(2), 187-221. Schrand, C. and Wong, M. (2003) “Earnings Management Using the Valuation Allowance for Deferred Tax Assets under SFAS No. 109” Contemporary Accounting Research, 20 (3), 579-611. Wall, L. and Peterson, D. (1987) “The Effect of Capital Adequacy Guidelines on Large Bank Holding Companies” Journal of Banking & Finance, 11 (4), 581-600. ______ and __________ (1995) “Bank Holding Company Capital Targets in the Early 1990s: The Regulators Versus the Markets” Journal of Banking & Finance, 19 (3-4), 563-574.
Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.
No, abandon capital (safety) in return of profitability is not what regulators desire. Regulators care more about the well-being of banks owner and banking system. As I mentioned before, there is a trade-off between safety and profitability. Holding too less capital will largely increase risk of bank’s debt insolvency. A certain amount of capital is required to serve the bank as a buffer against the potential defaults and crisis. 【c】
Does the capital structure of a firm really matter? If so, how and why does it matter? Practitioners and scholars of corporate finance have debated these questions for several years and have found it difficult to come up with definitive answers. The classical work of Modigliani and Miller (1958) provided the impetus for what is now, orthodox corporate finance theory on the optimal capital structure of firms. They postulated that, in a perfect or frictionless capital market, the choice between debt and equity financing has no material effect on the value of the firm. Stern and Chew (2003) noted that following the Modigliani-Miller propositions, academic researchers in the 1960s and 1970s turned their attention to market imperfections that might make firm value depend on capital structure. They further noted that the main suspects were a tax code that encourages debt by making interest payments but not dividends tax-deductible and expected costs of financial distress that rise with increasing amount of debt. Towards the end of the 1970s, they noted, there was also discussion of signalling effects, such as the tendency for stock prices to fall significantly on the announcement of new equity issues and to rise on the news of stock buyouts. These effects seemed to confirm the existence of large information cost that could influence financing choices in the predictable ways.Myers (1984), however, noted that there is a conflict which has existed among the different theories and referred to is as the “capital structure puzzle.” Barclay and Smith (2005) noted that it has been the difficulty of coming up with conclusive tests of the competing theories. Firstly, they noted that model on capital structure typically are less precise than...
Parrino, R., Kidwell, D. S., & Bates, T. W. (2011). Fundamentals of Corporate Finance. Hoboken, NJ: John Wiley & Sons. (Original work published 2009)
Assessing the capital structure of any firm is important for investors attempting to determine if...
Bank of America is an international and widely known banking and financial corporation. Its headquarters are located in Charlotte, North Carolina, and the Bank of America is the second largest bank holding company in the United States of America. A bank holding company is a company that owns and controls one or more banks, but does not necessarily take part in the act of banking itself. This gives it a greater range of flexibility that enables it to raise capital for itself more easier than a traditional bank. Other benefits include: “The holding company can assume debt of shareholders on a tax free basis, borrow money, acquire other banks and non-bank entities more easily, and issue stock with greater regulatory ease.”. In essence, this grants the bank holding company a much more freely moving business that has a distinct advantage over its lesser bank brethren. Bank of America has a variety of interesting topics that will be extensively and thoroughly covered. These include Bank of America’s history, its financial and stock analysis, its multitude of operations, and the large number of controversies that surround the Bank. Once the said topics have been rigorously and exhaustively described, the beautiful conclusion will rear its head and allow the reader to bask in the satisfaction of finishing this extremely interesting paper.
Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. That is, you cannot change the size of a cake by cutting it into different sized pieces. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk.
There is a vast amount of literature available on the additional procyclicality of regulatory capital charges in Pillar 1 of Basel II. In this section, we shall briefly visit this literature and see if any conclusions can be drawn from this, before proceeding to the conclusion and mitigation of these procyclical effects. The majority of the literature, as expected, focuses primarily on the IRB approach, as this aspect of Basel II has drawn the most criticism from financial practitioners and academics alike. The greater part of this literature has found that there is an overwhelmingly substantial rise in procyclicality of minimum regulatory capital charges originating from the IRB approach. Gordy and Howells found that under the IRB approach, volatility in the capital charge, relative to the mean, is between 0.1 to 0.26 (Gordy & Howells, 2004). This follows another study by Kashyap and Stein, which shows that capital charges rose by 70-90% during the years of 1998 to 2002 dependant of the model used to calculate PD’s (Goodhart & Taylor, 2004).
...ence of Capital Measurement and Capital Standards’, Basle Committee on Banking Supervision, vol.1, no.1, p1-28.
For example, two of the goals set for 2015 were to “deliver modest positive operating leverage on our core expense base and significantly reduce the drag on earnings due to legal and repositioning costs” (Citigroup, 2016, p.2). Revenues increased by 3% and core operating expenses remained flat. Moreover, Citi’s net income reflects strong earnings for a company that lower headcount, created a more focused footprint and changed its mix of businesses and assets (Citigroup, 2016). It is important to note, that within the financial services industry, many banks have struggled to comeback from the financial crisis in 2008- 2009. Citi’s financial statements is evidence of its efforts to regain momentum despite the negative impact of its Banamex scandal.
The recent M & A transactions for 4 of the intervened banks were largely driven by the need to address their deficient capital positions. The transactions were largely assisted by the Regulatory Authorities through the provision of technical support in the form of advice. While the development is expected to resolve the problems of the intervened banks, there are obvious issues and challenges that should be addressed both by the Regulatory Authorities and operators in order to derive maximum benefits from the outcome of the transactions. Kai (2002) summarized the major problems that are still inherent in many banks in Nigeria
Establishing new targets for bank’s capital and return on equity – 12-13% Common Equity Tier1 (CET1) ratio and 10% Returns on Equity
The comparison of banks based on Efficiency ratio is fast and feasible. The ratio is considered to be meaningful for investors. Comparisons of banks in different countries reveal significant differences in interest rates, commission fees and factor costs. As these elements are incorporated in the efficiency ratio calculation, banks situated in a country with comparatively high interest margins ceteris paribus appear to be more productive than others. The balance sheet policy of a bank affects the refinancing costs along the yield curve. These costs are considered in the interest earnings and thus have an impact on the efficiency ratio as
The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
The above estimation has left some questions pertaining to fill the gap by attempting to identify and measure factors that determine the profitability performance of commercial banks in Malaysia. What are bank-specific determinants and macroeconomic determinants influence on banks’ profitability in Malaysia compare to other countries? Do capitalized bank is contribute more on bank performance compare to other variables? Did relationships between determinants of banks’ profitability change during the financial crisis? This study therefore, intends to examine the bank specific and macro determinants on banks’ profitability, the impact capital and financial crisis on banks profit. To answer the research questions, the dissertation selected 27 commercial banks in Malaysia including local and foreign banks to fill this gap.