Unit-10:

The Management of a Bank’s Equity Capital Position

• Many tasks performed by Bank Capital

• Types of Bank Capital
• Measuring the size of Bank Capital
• How much Capital does a Bank need?
• Banks under pressure today to raise more Capital
• Planning for meeting a Bank’s Capital needs
• Raising Capital Internally to fulfill the Bank’s Plan
• Raising Capital Externally to fulfill the Bank’s
Plan
• Many tasks performed by Bank Capital:
• In the first place, capital provides a cushion
against the risk of failure by absorbing
financial and operating losses until
management can address the bank's problems
and restore the institution's profitability.
• Second, capital provides the funds needed to
get the bank chartered, organized and
operating before deposits come flowing in.
• A new bank needs starting up funding to
acquire land, build a new structure or lease
space, equip its facilities, and hire offers and
staff even before opening day.
• Third, capital promotes public confidence in
a bank and reassures its creditors (including
the depositors) of the bank's financial
strength.
• Capital also must be strong enough to
reassure borrowers that the bank will be able
to meet their credit needs even if the
economy turns down.
• Fourth, capital provides funds for the organization's
growth and the development of new services,
programs, and facilities.
• When a bank grows, it needs additional capital to
support that growth and to accept the risks that come
with offering new services and building new facilities.
• Most banks eventually outgrow the facilities they start
with.
• An infusion of additional capital will permit a bank to
expand into larger quarters or building additional
branch offices in order to keep pace with its
expanding market area and follow its customers with
convenient service offerings.
• Finally, capital serves as a regulator of bank
growth, helping to ensure that the individual bank's
growth is held to a pace that is sustainable in the
long run.
• Both the regulatory authorities and the financial
markets require that bank capital increase roughly in
line with the growth of loans and other risky bank
assets.
• Thus, the cushion to absorb losses is supposed to
increase along withy a banking institution's growing
risk exposure.
• Types of Bank Capital:
There are several different types of bank capital:
– Common stock,
– Preference share,
– Share Premium,
– Undivided profits,
– Equity reserves,.
– Subordinated debentures,
• Common stock, measured by the par (face) value of
common equity shares outstanding, which pay a
variable return depending on whether the bank's
board of directors votes to pay a dividend.
• Preference share, measured by the par value of any
shares outstanding that promise to pay a fixed rate
of return
• Preferred stock may be perpetual or have only
limited life.
• Share Premium, representing the excess amount
above each share of stock's par value paid in by the
bank's shareholders.
• Undivided profits, or Retained Earnings representing
the net earnings of the bank that have been retained in
the business rather than being paid out as dividends.
• Equity reserves, representing funds set aside for
contingencies such as legal action against the bank, as
well as providing a reserve for dividends expected to
be paid at not yet declared and a sinking fund to retire
stock or debt in the future.
• Subordinated debentures, representing long
term debt capital contributed by outside
investor's whose claims against the bank
legally follow (i.e.', are subordinated to) the
claims of depositors
• These debt securities may carry a
convertibility feature, permitting their future
exchange for shares of bank stock.
• Measuring the size of Bank Capital:
– By book value: recorded at the value they
contained on the day they were acquired or issued
and posted on the bank’s books.
– Regulatory capital: as per the directives issued by
the concerned regulatory agency. For example, in
Nepal, banks can include in their capital only those
items which NRB has specified in their directives.
– Market value capital: by multiplying number of
shares by current market price.
• How much Capital does a Bank need?:
– The main function of a bank is to perform an
intermediation role.
– For this purpose banks mobilize deposits from
savers and deploys that fund towards investors.
– The nature and risks in both these elements are
completely different.
– There may be chances of default from borrower
side, whereas, banks can not default towards
depositors.
– For this purpose, regulators require banks to have
a good base of capital.
– The main purpose of banks requiring to have
capital is to make sure that banks are able to
return funds to the borrower, even in case of their
failure to receive funds from the borrower.
– Initially, regulators thought if banks are required
to have a minimum paid up capital before they
are licensed, that would solve the problem.
– So everywhere, banks were prescribed to have a
minimum paid up capital before they were
authorized to start their operation.
– Initially it worked.
– The deficiency in this approach is it fails to take
into account the volume of business banks were
undertaking.
– The more volume of business, the more risks
bank is taking.
– Under this approach, banks were not required to
have more capital even in case where they have
expanded their business to a large extent.
– So the authorities started to link the required
capital with the volume of assets which banks
were having.
– Around beginning of 1980s, serious deficiencies
started to be seen even in this approach.
– For example, two banks may have the same
balance sheet size (same asset size).
– But it may be, one bank has provided loan to
very risky sectors/ borrower, whereas the other
bank have provided loans in a very conservative
and safe manner.
– But both will be required to have same capital
size under this approach.
– Another problem in this approach was it linked
required capital only with the balance sheet size.
– It completely ignored the off balance sheet
activities of banks.
– Because off balance sheet activities will not be
recorded in the balance sheet, banks were not
required to have capital for undertaking these off
balance sheet activities.
– In this background that Basel 1 was framed in
1988.
– Basel 1 refers to the guidelines with regard to the
required capital banks must posses.
– They have been called Basel guidelines because
they are issued by BIS (Bank for International
Settlements) located at a Switzerland city by the
name of Basel.
– As per German language, this city is called
Basle. So, sometime this guideline is also called
Basle guidelines.
• Prior to Basel (I)

• Capital
• Capital Adequacy ------------- X 100
• Assets
 Basel (I) (After 1988)

• Capital Fund
• Capital Adequacy ---------------- X 100
• Risk Weighted Exposures

• (Core + Supplementary)
• = --------------------- X 100
• Risk Weight X (Assets + Off Balance Sheet Exposures)
• Banks under pressure today to raise more
Capital:
– Every bank would like to grow
– This requires more transaction (more loans and
advances)
– This increases the risks for the banks
– Regulators require banks to have adequate capital
before banks enhance theor loan portfolio
– Thus banks everywhere under pressure to raise
more and more capital
• Planning for meeting a Bank’s Capital
needs:
• Phase one: develop an overall financial plan
for the bank
• Phase two: determine the amount of capital
that is appropriate for the bank given its
goals, acceptable risk exposure and
prevailing regulations
• Phase three: determine how much capital can
be generated internally through profits
retained in the business
• Phase four: evaluate and choose the best
source: for example between equity and debt