Chapter 9

Chapter 9
The theory of capital structure for an insured bank
Regulatory capital-adequacy standards as implicit
pricing of risk and to distinguish among GAAP, RAP, and
market measures of bank capital
Practical aspects of bank capital and dividend
management as captured by, among other things, a
bank’s confidence function, internal and external
sources of capital, strategies for capital formation
(including share repurchases), and the use of securities
innovations such as trust-preferred stock
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Cost of Bank Capital
Recent Developments:
 Basel Accord on risk-based-capital (RBC)
requirements (1992) – Mandates that banks
and BHC’s determine their regulatory capital
based on their exposure to credit risk
 Federal Deposit Insurance Corporation
Improvement Act (FDICIA) (1991) –
Attempts to reduce the moral-hazard and
agency problems inherent in mispriced
deposit insurance
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Modigliani and Miller (M&M)
(Figures 9-1 , p. 263)
In a perfect capital market without
bankruptcy costs and taxes, M&M have
shown that the value of the firm is
independent of its financial structure.
But, to understand how financial
structure affects the value of the firm,
the concepts of tax shield and
bankruptcy costs are critical.
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Tax Shield of Debt
Tax deductibility of interest expense
increases the total income that a
levered firm can pay out to both its
stockholders and its bondholders.
The value of the firm is equal to its
value as a purely equity-financed firm
plus the present value of the tax shield.
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Bankruptcy Costs
What stops firms from becoming purely
debt-financed entities? Bankruptcy
Costs/Costs of Financial Distress
 As a firm increases its use of debt, its
risk of not being able to cover its
interest expenses increases.
 Greater leverage eventually leads to a
higher cost of capital.
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Federal Safety Net
The government guarantee (“G”) is the federal
safety net for banks.
Consists of deposit insurance, the Fed’s discount
window, and the too-big-to-fail (TBTF) doctrine.
Deposit Insurance and the Value of the Banking Firm
(Fig. 8-3, p. 265, Buser, Chen and Kane [1981])
Conclusion: Banks accept regulatory interference
because DI enhances the value of the banking firm
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The Costs of Bank Financial
Market Discipline – Increased cost of funds
Regulatory Discipline - Increased regulatory
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Regulatory Interference and
Capital Regulation
Agency conflicts arise because of
asymmetric information, dishonesty
(moral hazard), and different goals and
The K in TRICK, which is the umbrella
idea for regulatory interference
attempts to resolve these agency
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Cost of Equity Capital
The return that shareholders expect to earn
on their investment represents the implicit
cost of equity capital.
The expected total return [E(r)] can be
viewed in terms of a dividend yield (D/P)
and a price-appreciation or capital-gains
yield (ΔP/P):
[E(r)] = D/P + ΔP/P
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A Bank’s Confidence Function
Without G, confidence is function of
capital adequacy (the K in TRICK),
stability of earnings, and quality of
information (the T in TRICK)
With G, banks have substituted G for
the other factors but especially capital
See Figure 9-2 for a long view of bank
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Risk Management and
Regulatory Capital Standards
Basel Accord – Mandates risk-based capital
requirements for all banks regardless of their
size thus marking a formal linkage between
bank capital and risk management.
By 12/31/92, all U.S. commercial banks and
BHCs had to meet minimum risk-based
capital requirements established jointly by
the Federal Reserve, the Office of the
Comptroller (OCC), and the Federal Deposit
Insurance Corporation (FDIC).
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Basel Reform
(forthcoming 2002? 2003?)
Existing (1992) weights for credit risk are too
Bond-type ratings as shown in Table 9-2
represent an improvement
In addition, comprehensive RBC requirements
must take account of all the risks a bank
See Table 9-2 (p. 272) and Box 9-2 (p. 276)
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The Regulatory Dialectic in
Working Group on Public Disclosure
(Box 9-1, p. 273-275)
Cynic’s view is that the regulators are in
the industry’s hip pocket and that they
only give the industry what it wants
More benign view is that of a working
relationship as captured by the letter in
Box 9-1
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Three Different
Accounting Standards
The Many Veils of Bank Bookkeeping
1. Book-Value Accounting (GAAP)
2. Regulatory Accounting (RAP)
3. Market-Value Accounting
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To measure bank capital or accounting
net worth, subtract the book value of
liabilities from the book value of assets:
NW = A – L, as long as NW > 0
If NW < 0, the bank is book-value
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Bankers prefer not to raise more costly
equity to appease regulators, so they have
regulators accept other instruments as
regulatory capital.
The idea is to incorporate securities into a
bank’s capital structure that will be priced
based on the bank’s risk exposure and
thereby affect the bank’s cost of funds.
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Market Value
The total equity value of the firm is equal to:
MVE = P x N
P = Price Per Share
N = Number of Shares Outstanding
Critics claim market value accounting is much
too volatile a measure versus book values
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How Much Capital Is
“In both banking and industry, the adequacy
of capital is an elusive measure. Perhaps the
only real determinant is the aggregate
consensus of the marketplace – that is,
leverage, or the inverse of the capital ratio,
should be extended until the marketplace
reacts adversely and reflects concern.”
James Ehlen
Goldman Sachs
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What’s the “Magic” Number?
(Wayne Angell, former Fed Governor, 1991)
“While picking an exact number is difficult, I am
thinking of minimum bank capital on the order of ten
percent tier one capital to risk-weighted assets. If
ten percent seems surprisingly high, recall that prior
to the institution of deposit insurance, bank capital
ratios were normally above twenty percent.
Moreover, median capital ratios in financial-services
industries that do not have deposit insurance are
today significantly higher than ten percent. Clearly,
any move to increase bank capital requirements
would need a long transition period, to minimize the
problems banks might face raising capital.”
See Figure 9-2, p. 264
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Key Components of Bank Capital
Common Stock
Retained Earnings or undivided profits
Table 9-3, p. 284, shows Citigoup/Citibank
capital structure
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Internal Capital
Generation Rate (g)
An important concept for the financial
management of bank equity capital is
the internal capital generation rate (g):
g ≈ ROE x RR
RR = Retention Rate – 1 minus the payout
ratio (RR = 1 – PR)
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External Sources of Capital
When regulatory or market forces or both
require a bank/BHC to increase its capital
beyond its internal capital generation rate,
the bank must turn to external sources of
Although both equity and debt capital are
available for such purposes, under new the
new guidelines of 1992, common equity has
been assigned a more critical role.
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Inadequate Capital and Ability
to Obtain Equity Financing
The inability to access capital
markets can be taken as an
indicator of distressed bank’s lack
of viability or going-concern value.
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Other CapitalFormation Strategies
In addition to raising capital in debt and
equity markets, banks have three additional
“internal” methods for generating capital:
Dividend Reinvestment Plans
Employee Stock Ownership Plans
Stock Dividends
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Dividend-Reinvestment Plans
Since these plans substitute stock dividends
for cash dividends, they permit banks to
conserve retained earnings that otherwise
would be paid out in the form of cash
Banks typically offer a five-percent discount
from fair market value to encourage
participation in dividend-reinvestment plans.
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Employee Stock Ownership
Plans (ESOPs)
Since ESOPs fall under unique tax legislation,
they are the only tax-deductible employee
benefit plan that can be used as a direct
source of capital for a bank.
As a result, ESOPs can be financed largely
with pretax dollars.
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Stock Dividends
Used in conjunction with ESOPs and thus
offers a dual way for banks to raise capital.
A stock dividend is simply a payment to
shareholders in the form of stock rather than
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Banking and Investment
The relationship with an investment bank eases the
burden of raising capital and worrying about the
appeal of the bank’s stock.
Many community banks do not have relationships
with investment banks but should follow two basic
guidelines in searching for one:
Consider the range and content of investment-banking
services that are needed.
Follow a formal selection procedure in selecting an
investment-banking firm so as to establish a “presence” as
a client.
Chapter 9
Stock-Repurchase Plans
A company uses cash to buy back some of
its outstanding shares.
Share repurchases are in increasingly
popular way for firms to pay cash to their
shareholders, as opposed to paying cash
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Does bank capital structure matter?
Regulatory discipline captured by the K in
TRICK for Kapital Adequacy has always been
important, that’s why FDIC stands for Forever
Demanding Increased Capital and the Basel
Accord focuses on risk-based capital
Market discipline also counts and affects a
bank’s cost of funds
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Chapter Summary (concluded)
Defining bank capital is a thorny issue:
“It must be perpetual but it doesn’t
have to be forever. It has to feel like
equity but look – to tax authorities –
like debt. Defining banks’ core capital is
one of the thorniest issues facing bank
Anthony Currie, Euromoney
Chapter 9