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.
Reimers, Jane L. (2003). Financial Accounting A Business Process Application. Upper Saddle River, New Jersey, Prentice Hall.
Many economist argue that placing stricter equity requirements on banks would increase the cost of lending, thus slowing down economic investment and hampering the economy’s growth. This is the reasoning behind the steady decline of capital that banks are required to hold. By decreasing reserve requirements, more loans can be made hence more economic activity, which hopefully results in economic growth. One problem with this counterargument is that once growth starts to slow down and markets begin to regress, the banker’s equity gets wiped out of their investments much sooner if they only commit 3% of equity compared to the 25% that they were once responsible for up
By the mid-1980s, US commercial banks were subject to primary capital requirements set by the SEC, OCC and FDIC while US securities firms were subject to the SEC's Uniform Net Capital Rule (UNCR).
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
One of the major unintended impacts of the Dodd-Frank Act has been on credit unions and community banks. These banks weathered the credit crisis and lost only 6% of their share of banking assets between 2006 and mid-2010. A recent Harvard study indicates that this decline accelerated to 12% since the passage of the Dodd-Frank in July 2010. [a] While the community banks’ earnings increased by 12% to $5.3 billion by mid 2015 the number of these banks had declined according to Federal Deposit Insurance Corporation. The number of banks with assets under $1 billion has declined from around 7500 in 2010 to less than 6000 since Dodd-Frank came into effect. [b] Increased compliance costs due hiring of new personnel to interpret the new regulations compelled these banks to cut down on customer service amongst other things. The law hurt them disproportionately and forced them to consolidate. Regulatory economies of scale drive the process of consolidation. A larger bank is often more equipped at handling increased regulatory burdens
Marshall, M.H., McManus, W.W., Viele, V.F. (2003). Accounting: What the Numbers Mean. 6th ed. New York: McGraw-Hill Companies.
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).
Albrecht, W. S., Stice, J. D., Stice, E. K., & Skousen, k. F. (2002). Accounting Concepts and Applications. Cincinnati: South-Western.
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.
It was the conclusion of the author that financial ratios when combined with statistical analysis still remain a valuable tool. The theoretical conclusion was that ratios used within a multivariate framework take on a more influential role than when used in isolation. The discriminate model was very accurate in the initial sample of 66 firms, correctly predicting 94 percent of the original bankrupt firms. The potential suggested used of the model included: business credit evaluation, investment guidelines and internal control procedures. The MDA model also showed potential to ease some problems in the selection of securities of a portfolio but further investigation was recommended.
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
Modigliania, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review.
Marshall, D. H., McManus, W. W, & Viele, D. (2002). Accounting: What the Numbers Mean. 5th ed. San Francisco: Irwin/McGraw-Hill.
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.
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.