MANAGEMNT OF CAPITAL IN BANKS

The future of banking is becoming clearer. It is a future of more capital, more liquidity and less risk. And, inevitably, it is a future with lower returns on capital, higher costs of doing business and slower growth with ultimate effects to be felt by shareholders and end consumers. Greater scrutiny by investors, regulators and other stakeholders regarding balance sheet usage is also expected. Basel III is set to redraw the banking landscape. It will have a profound impact on profitability and force many banks to transform their business models. It will also require firms to undertake significant process and system changes. The good news is that most banks are expecting to meet the more stringent requirements without raising additional capital, as reported in recent bank earning releases. In addition, the Basel III framework does not begin to come into operation until January 2013 and its full effects will not be felt before January2019, when the new regimes transitional period ends.

Capital management strategies

Banks should assess the impact of the new rules on their capital adequacy through a comprehensive capital planning and optimization/mitigation process. The size of the capital increase impact, the need to deliver promised RWA savings and the limited room for volatility surrounding compliance with minimum Basel III capital targets all reinforce the need for RWA optimization programs, These programs should do the following : Estimate RWA impact by business line and product including sources of increase. Evaluate alternative RWA mitigation/ de-risking and capital re-allocation strategies. Assess impact on business model and marginal risk-adjusted returns of proposed actions. Optimize mix of RWA initiatives and plan savings in capital requirements over a threeyear horizon. Evaluate overall capital strategy including organic generation in combination with their dividend and share repurchase programmers and various proposed RWA mitigation scenarios. Calibrate capital structure, emphasize high-quality equity, manage impact of new Basel III deductions, phase out hybrid capital instruments and evaluate contingent capital instruments.

BANK CAPITAL SOURCES

Capital Requirements
Overview
Capital is a key requirement for successfully operating financial institutions, representing the commitment of money and property that the bank's owners have made to their institution. And based on their long experience, regulators note that capital is essential for the long-term success of an institution's operations.

The Need for Capital

Capital supports all aspects of the operations of an institution, and minimum levels of capital are mandated by laws and regulation. One of these laws defines prompt corrective action (PCA) on the part of the regulators if capital levels are not maintained, and it mandates minimum levels of capital during the ongoing operations of the bank. Other capital restrictions relate to specific circumstances, such as initial capital, investments in bank premises, and the payment of dividends.

Raising Capital
Because capital is considered so vital to the safe operation of a financial institution, raising capital is a key step in the ultimate success of a new bank. The amount of capital necessary for any bank will be influenced by several factors, including the bank's prospects for growth, as well as its mission. Traditional sources of bank capital include funds raised from the founders group, from the foundation of a bank holding company, from supporting financial institutions, and also from special sources of funding available for community development banks.

Capital and Controlling Interests

The Bank Holding Company Act provides rules that govern the investment in bank and bank holding company stock by corporations, trusts, and certain other companies. If a company owns or controls 25 percent or more of the total equity capital of a bank or BHC (even nonvoting stock), the investing company is deemed to have a controlling influence over the bank/BHC. There have been exceptions where the Federal Reserve has permitted a company to own more than 25 percent of the total equity of an MOI/BHC without being considered as controlling it. The Federal Reserve will continue to show flexibility for allowing nonvoting equity investments between 25 and 50 percent, particularly in troubled situations, but with requisite

conditions. When the Federal Reserve permits nonvoting equity investments above 25 percent, it may require passivity commitments, no interlocks, and limited business relationships.

SOURCES OF CAPITAL :
As mentioned before, banks basically make money by lending money at rates higher than the cost of the money they lend. More specifically, banks collect interest on loans and interest payments from the debt securities they own, and pay interest on deposits, CDs, and short-term borrowings.

Deposits
The largest source by far of funds for banks is deposits; money that account holders entrust to the bank for safekeeping and use in future transactions, as well as modest amounts of interest. Generally referred to as "core deposits," these are typically the checking and savings accounts that so many people currently have. In most cases, these deposits have very short terms. While people will typically maintain accounts for years at a time with a particular bank, the customer reserves the right to withdraw the full amount at any time. Customers have the option to withdraw money upon demand and the balances are fully insured,therefore, banks do not have to pay much for this money. Many banks pay no interest at all on checking account balances, or at least pay very little, and pay interest rates for savings accounts.

Wholesale Deposits
If a bank cannot attract a sufficient level of core deposits, that bank can turn to wholesale sources of funds. In many respects these wholesale funds are much like interbank CDs. There is nothing necessarily wrong with wholesale funds, but investors should consider what it says about a bank when it relies on this funding source. While some banks de-emphasize the branch-based deposit-gathering model, in favor of wholesale funding, heavy reliance on this source of capital can be a warning that a bank is not as competitive as its peers.

Share Equity
While deposits are the primary source of loan able funds for almost every bank, shareholder equity is an important part of a bank's capital. Several important regulatory ratios are based upon the amount of shareholder capital a bank has and shareholder capital is, in many cases, the only capital that a bank knows will not disappear. Common equity is straight forward. This is capital that the bank has raised by selling shares to outside investors. While banks, especially larger banks, do often pay dividends on their common shares, there is no requirement for them to do so. Banks often issue preferred shares to raise capital. As this capital is expensive, and generally issued only in times of trouble, or to facilitate an acquisition, banks will often make these shares callable. This gives the bank the right to buy back the shares at a time when the capital position is stronger, and the bank no longer needs such expensive capital. Equity capital is expensive, therefore, banks generally only issue shares when they need to raise funds for an acquisition, or when they need to repair their capital position, typically after a period of elevated bad loans. Apart from the initial capital raised to fund a new bank, banks do not typically issue equity in order to fund loans.

Debt
Banks will also raise capital through debt issuance. Banks most often use debt to smooth out the ups and downs in their funding needs, and will call upon sources like repurchase agreements or the Federal Home Loan Bank system, to access debt funding on a short term basis. There is frankly nothing particularly unusual about bank-issued debt, and like regular corporations, bank bonds may be callable and/or convertible. Although debt is relatively common on bank balance sheets, it is not a critical source of capital for most banks. Although debt/equity ratios are typically over 100% in the banking

sector, this is largely a function of the relatively low level of equity at most banks. Seen differently, debt is usually a much smaller percentage of total deposits or loans at most banks and is, accordingly, not a vital source of loanable funds. Some other common sources are borrowing from financial markets, borrowing from

governments through bonds and other securities, fees from consultancy and other services offered by the bank.

LONG TERM DEBT :

Loans and financial obligations lasting over one year. Long-term debt for a company would include any financing or leasing obligations that are to come due in a greater than 12-month period. Such obligations would include company bond issues or long-term leases that have been capitalized on a firm's balance sheet. Bank loans and financing agreements, in addition to bonds and notes that have maturities greater than one year, would be considered long-term debt. Other securities such as repos and commercial papers would not be long-term debt, because their maturities are typically shorter than one year.

Why do we need long term debt :

At the current time, when India is endeavoring to sustain its high growth rate, it is imperative that financing constraints in any form be removed and alternative financing channels be developed in a systematic manner for supplementing traditional bank credit. In this context, the development of long-term debt markets corporate debt and municipal debt is critical in the mobilization of the huge magnitude of funding required to finance potential business expansion and infrastructure development. Following are the reasons : a) Ensuring financial system stability: A liquid corporate bond market can play a critical role because it supplements the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation. Banking systems cannot be the sole source of long-term investment capital without making an economy vulnerable to external shocks. Historical and cross-

sectional experience has shown that systemic problems in the banking sector can interrupt the flow of funds from savers to investors for a dangerously long period of time. b) Enabling meaningful coverage of real sector needs: The financial sector in India is much too small to cater to the needs of the real economy. The banks in India are unable to meet the scale or sophistication of the needs of corporate India. Needless to say, the financial system is not big enough to meet the needs of small and medium-sized enterprises either. c) Creating new classes of investors: Commercial banks face asset-liability mismatch issues in providing longer-maturity credit. Development of a corporate debt market will enable participation from institutions that have the capacity as well as aptitude for longer maturity exposures. Financial institutions like insurance companies and provident funds have long-term liabilities and do not have access to adequate high quality long-term assets to match them. Creation of a deep corporate bond market can enable them to invest in long-term corporate debt, thus serving the twin goals of diversifying corporate risk across the financial sector and enabling these institutions to access high quality long-term assets. Thus, access to long-term debt opens up the market to new classes of investors with an appetite for longer maturity assets and thereby helps prevent maturity mismatches. d) Reduced currency mismatches: The development of local currency bond markets has been seen as a way to avoid crisis, not only by supplementing bank credit but also because these markets help reduce potential currency mismatches in the financial system. Currency mismatches can be avoided by issuing local currency bonds. Thus, well-developed and liquid bond markets can help firms reduce their overall cost of capital by allowing them to tailor their asset and liability profiles to reduce the risk of both maturity and currency mismatches. e) Term structure and effective transmission of monetary policy: The creation of long-term debt markets will also enable the generation of market interest rates at the long end of the yield curve thus facilitating the development of a more complete term structure of interest rates. A deeper, more responsive interest rate market would in turn provide the central bank with a mechanism for effective transmission of monetary policy.

RECAPITALISATION :
Recapitalization is a sort of a corporate reorganization involving substantial change in a company's capital structure. Recapitalization may be motivated by a number of reasons. Usually, the large part of equity is replaced with debt or vice versa. In more complicated transactions, mezzanine financing and other hybrid securities are involved.

Types of Recapitalization
Leveraged Recapitalization
One example of recapitalization is a leveraged recapitalization, wherein the company issues bonds to raise money, and then buys back its own shares. Usually, current shareholders retain control. The reasons for this sort of recapitalization include:

Desire of current shareholders to partially exit the investment Providing support of falling shareprice Disciplining the company that has excessive cash Protection from a hostile takeover Rebalancing positions within a holding company

Leveraged Buyout
Another example is a leveraged buyout, essentially a leveraged recapitalization initiated by an outside party. Usually, incumbent equityholders secede control. The reasons for this transaction may include:

Getting control over the company via a friendly or hostile takeover Disciplining the company with excessive cash Creating shareholder value via gradual debt repayment

Nationalization
Another example is a nationalization, wherein the nation in which the company is headquartered buys sufficient shares of the company to obtain a controlling interest. Usually, incumbent equityholders lose control. The reasons for nationalization may include:

Saving a very valuable company from bankruptcy Confiscation of assets Executing the eminent domain right

Capital deficiency
We do not often hear the expression non operating liabilities in valuation. When we hear about the concept, it is either non operating assets, or excess working capital. A deficiency in working capital, then, is the other side of the equation. Several recent engagements have reminded me of the import of normalizing working capital before using an income approach to valuation, be it a DCF, CCF or excess earnings method. When the premise of value is that of a going concern, the working capital assumption must be consistent with the industry norm, i.e., what a hypothetical buyer/seller would expect. A particular medical practice being valued may not necessarily have a normal level of working capital. Typical sources of working capital deficiencies include patient prepays or credit balances, accruals in excess of available cash for retirement plan contributions, and accrued vacation time, sick time or "personal time" where the practice permits unlimited or significant carryovers. Accruals for personal time were long ago identified as an issue for GAAP financial reporting. Given that the typical medical practice sale is structured as an asset sale, the proceeds of that sale must be used to pay off all outstanding liabilities before anything is distributed to equity holders. If the subject practice permits unlimited carryovers of personal time, the magnitude of the liability may be shocking. Sufficient effort must be expended to determine what a normal level of personal time accrual is in order to have an appropriate measure of working capital in the valuation model. Even in simple buy-in transactions, the valuation analyst or consultant must be certain to inquire as to this liability. Excluding it could result in the younger owners being left "holding the bag" at some point in the future for a large unfunded liability - analogous to those defined benefit obligations of airlines and "old economy" manufacturers.