The Capital Structure of Banking Institutions
Banking institutions can finance their assets in various ways. The costs of the various types of financing reflect, inter alia, the risk that depositors and investors incur. The largest banking institutions generally have a larger ratio of external financing than the smaller banking institutions. This may indicate that the largest banking institutions apply more sophisticated management tools in connection with capital allocation. New capital-adequacy rules contribute to greater consistency between the risks that banking institutions incur and the capital requirement.
Banking institutions differ from other companies in that they have the sole right to approach the general public to obtain deposits. Protection of depositors is an important reason for the public regulation of banking institutions, including capital adequacy requirements and the deposit guarantee scheme. So the risk incurred when making an ordinary deposit to a banking institution is moderate.
Banking institutions are subject to a requirement to hold a certain level of liable capital. Liable capital constitutes actual equity capital[1] (primarily share capital and reserves), but may also include external financing that has some of the characteristics of equity capital. This subordinate capital comprises external financing that in the event of compulsory liquidation[2] is not repaid until other debt has been settled. Consequently the distinction between equity capital and external financing is not as clear-cut for banking institutions as for other, companies.
Banking institutions' financing costs
A banking institution's financing structure (capital structure) affects its financing costs, i.e. the size of the return required by the various types of capital contributors for placing funds with the banking institution. This required return depends on e.g. the maturity and the risk which the financing is deemed to involve.
Chart 49 shows the average costs of the various types of financing for Danish banking institutions in 2002 and the return on equity.
There seems to be a degree of correlation between the risk incurred by capital contributors, i.e. maturity and debt ranking in the event of compulsory liquidation, and the return achieved.
The costs of deposits, debt to other credit institutions and issued bonds are relatively low. The small variations in the Chart are, inter alia, attributable to the calculation method, which does not take into account balance-sheet fluctuations during the year, and the low level of interest rates. Among the various types of financing, deposits involve the smallest risk. Deposits are to a large extent covered by the deposit guarantee, and deposits can be withdrawn without or at short notice. Debt to other credit institutions typically comprises short-term loans. Issued bonds are also primarily short-term loans based on negotiable securities. The calculated spread of interest rates between debt to other credit institutions and issued bonds may be related to the fact that issued bonds are negotiable, and that investors therefore pay a liquidity premium. However, it may also reflect that bonds are not issued at par, which the calculation does not take into account.
Mortgage-credit lending is subject to the balance principle, and the interest expenditure on issued mortgage-credit bonds therefore more or less corresponds to the interest income from mortgage-credit lending on the asset side.
Subordinate capital is a sort of hybrid between external financing and equity capital, and the interest on this type of capital lies between the two. Subordinate capital typically has a longer maturity than other external financing, except for mortgage-credit bonds, and in the event of compulsory liquidation ranks after all other external financing. So ordinary deposits and other non-subordinate external financing must be fully covered before payment can be made to contributors of subordinate capital.
Equity capital gained a higher return than the other types of financing, one reason being that equity capital bears the operational risk. The returns required by shareholders will increase with the proportion of external financing, since a higher external financing ratio means that higher fixed interest costs is to be paid before any return on equity. The relatively high return apparent from Chart 49 should be interpreted with caution, since it only relates to a single year. Return on equity is residual and it will therefore fluctuate more than the costs of other financing sources.
Banking institutions' capital structure
The costs of the various types of financing affect how banking institutions are financed. The capital structures of three categories of banking institutions are shown in Table 6. The categories are described in Box 11.
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Box 11
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The analysis operates with three categories of banking institutions: groups, comprising three Danish banking groups with both banking and mortgage-credit activities on their balance sheets; medium-sized banking institutions, comprising 10 large Danish banking institutions; and finally 23 smaller Danish banking institutions. This breakdown is not comparable to the breakdown in the chapter on the financial sector. It has been chosen because banking institutions with mortgage-credit activities have another balance-sheet structure than the other banking institutions. In addition, the size of a banking institution affects its balance-sheet structure. It should be noted that within each category there may be considerable differences between the individual banking institutions, and that the conclusions in the analysis are based on averages. |
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The equity ratio is lowest for the largest banking institutions and highest for the smaller banking institutions. This may indicate that the largest banking institutions apply more sophisticated management tools in connection with capital allocation, and that the large banking institutions are subject to greater shareholder pressure. Most of the small and medium-sized banking institutions apply ownership ceilings and/or limitations on voting rights, which can reduce shareholder pressure. In addition, small banking institutions often have a strong local base, and their shareholders focus not only on a high return on their shares, but also on e.g. the banking institution's role in the local community.
The largest banking institutions have the lowest ratio of deposits to total liabilities, while they have the highest ratio of issued bonds among the three categories of banking institutions. Debt to other credit institutions is used relatively most by the medium-sized banking institutions, while deposits are by far the most important source of financing for the small banking institutions. The small banking institutions have deposit surpluses, while the medium-sized and large banking institutions have deposit deficits.
On the other hand, the financing structure also depends on the asset structure. This is, inter alia, a consequence of the statutory requirement that the liable capital must constitute at least 8 per cent of the risk-weighted assets (the assets in the table are not risk-weighted). The credit risk on the share of lending comprising mortgage-credit lending is small, so that requirements of economic capital are less stringent than for ordinary bank lending. The smallest banking institutions have the largest share of ordinary bank lending, and thereby the highest capital requirement, all other things being equal, while the opposite is the case for the large groups that have a high ratio of mortgage-credit lending.
Chart 50 illustrates the relationship between the ratio of external financing to total liabilities and the return on equity, calculated as averages for the full period from 1996 to 2002 for the three categories of banking institutions.
For the large and medium-sized banking institutions the return on equity appears to increase with the ratio of external financing. This is not quite so pronounced in the case of the small banking institutions. Concerning the other types of financing, no equivalent correlation is seen, which reflects that equity investors run the risk of no return if the company is not in jeopardy.
Link between capital requirements and financial stability
If a banking institution is unable to meet its payment obligations, the whole banking sector may be affected. One banking institution may thus pose a risk to the entire financial system. The costs to an economy in the event of financial instability are very high, and this is why the authorities seek to ensure that the banking institutions have adequate capital.
When a banking institution grants a loan to a company, the company is in most cases monitored carefully by the banking institution, so that the latter may intervene if the risk on the loan is assessed to be excessive. This external monitoring is weakened to a degree when the company to be financed is a banking institution. This is because a significant proportion of the financing is deposits. Deposits of up to kr. 300,000 are covered by a deposit guarantee, which limits the incentive to consider the robustness of the individual banking institution. It should, however, be noted that even if there were no deposit guarantee schemes this would not necessarily lead to external monitoring via depositors. Most depositors have limited knowledge of the banking institutions' business area, so it is difficult for them to assess the level of risk to which a banking institution is subject
Large banks are assessed by rating agencies, and capital structure is an important parameter of the assessment. All else being equal, large equity capital entails a high rating, and thereby low borrowing costs. However, as stated, high equity capital may entail high overall financing costs, since equity capital is the most expensive source of financing. Rating is the systematic external monitoring of the banks, and thus helps to compensate for the possible lack of external monitoring by depositors. The authorities contribute, inter alia, to financial stability via legislation to ensure that the banking institutions have certain minimum capital. If a banking institution's capital base falls below the statutory requirement, the banking institution will lose its licence to operate. The capital reserves exceeding the capital requirement thus enable the banking institution to withstand unexpected losses. The purpose of the statutory capital requirement is, inter alia, to provide a degree of security that the equity capital does not become negative in the event of compulsory liquidation and thereby that the banking institution can be liquidated without losses to creditors, including the deposit guarantee scheme.
Under the statutory capital requirement, a banking institution's liable capital (equity capital and supplementary capital) must at all times constitute at least 8 per cent of the risk-weighted assets. The equity capital must be at least half the liable capital. It is difficult to determine the right level of the capital requirement. If the capital requirement is too low, it will not provide an adequate buffer, but if it is too high, it will impede the role of the banking institutions as providers of capital from depositors to borrowers. The 8-per-cent requirement is an international compromise taking both these considerations into account. The banking institutions themselves also have an interest in holding sufficient capital for any unexpected losses not to put the banking institution in jeopardy. In addition, a certain level of excess capital coverage may have a positive signal value.
The importance of new capital-adequacy rules
Work is underway to introduce new capital-adequacy rules for banking institutions, known as the Basle II rules[3]. While the existing capital-adequacy rules since the mid-1990s have allowed banking institutions to apply their own models for calculating market risks, this has not been the case for the banking institutions' primary risk, credit risk. The aim of the new rules is for the capital requirement to be determined on the basis of the banking institutions' own knowledge of the credit risk on exposures, or external rating agencies' credit ratings. The minimum capital requirement for banking institutions will still be 8 per cent of the risk-weighted assets. The new capital-adequacy rules include capital requirements to cover operational risks, i.e. technical or human errors.
The proposed new capital-adequacy rules include market discipline as an important element. The aim is for banking institutions to provide the financial markets with more detailed information on risks, capital structure and capital adequacy, risk management, etc.
To a higher degree than the existing set of rules, the proposed new rules take account of financial innovation, modern risk-management techniques, and internal control procedures. The new capital-adequacy rules are structured so as to give the banking institutions an incentive to expand and improve their risk management. On the other hand, the capital adequacy requirement may be relaxed to a certain degree. The rules can therefore mean that the share of the equity capital is reduced for the banks that apply sophisticated risk-management methods, i.e. primarily the large banks. The underlying philosophy is that the banking institution itself has the best overview of the risk profile, and that this overview must be applied when determining the capital adequacy. In relation to financial stability the new capital-adequacy rules will bring more consistency between the risk incurred by the banking institutions and the compilation of risk-weighted assets, and thus the capital requirement.
The introduction of the new rules is not expected to have any significant effect on the capital structure of the Danish banking institutions.
[1] In this context equity capital is used synonymously with core capital, one of the capital elements included in the compilation of credit institutions' capital adequacy.
[2] See Birgitte Bundgaard and Suzanne Hyldahl, Structure of the Banking institutions' Capital – New Statutory Requirements and Opportunities, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2002.
[3] For an in-depth description of the principles underlying the new capital-adequacy rules, reference is made to Suzanne Hyldahl, New Capital-Adequacy Rules for Banking institutions, Danmarks Nationalbank, Monetary Review, 1st Quarter 2001.