Question (1): Capital Structure and Financing in the Banking Industry
Australian banks are an interesting case of capital structure and financing considerations as far as companies go, in that they are regulated in a number of ways by the Australian Prudential Regulatory Authority (APRA) and the Reserve Bank of Australia (RBA).
Considerations of capital structure have the effect of reducing the cost of capital and so in turn increase the value of the firm (Ross, S. 2011).
APRA and the RBA together impose certain requirements on all Authorised Deposit-taking Institutions (ADIs) in relation to their capital make-up and their financing operations.
Differences in Capital Structure
ADIs are the only institutions permitted to engage in deposit taking activities. Customer deposits being a liability along with unsecured notes and which are therefore a form of ‘debt’ means that a large proportion of a bank’s capital is made up of this form of debt.
In addition to financial leverage considerations (i.e. debt to equity) banks must maintain a Capital Adequacy Requirement (CAR) which under the Basel II Accord stipulates that a bank must hold capital above an amount which is set by the Capital to Assets Ratio (CAR) of 8% Tier I and Tier II capital combined (with a minimum of 4% being of the Tier I type). This means that banks must have at least as much capital in the prescribed forms as represents 8% of its total assets (which are principally comprised of loans in a similar way as deposits comprise the majority of liabilities).
Capital in the form of ‘equity’ shares may be freely issued in the same way as any other form of company, just as a bank may use retained earnings to reduce the need to raise financing via any type of either debt or equity channel.
Since deregulation in the 1980s, Australian banks have adopted the strategy of making profits through liability management techniques. This involves borrowing funds at one interest rate – often from other banks - and lending funds out at a higher rate as a lender to borrowing customers. This financing approach is different to most ordinary companies, meaning that banks rely on issuing bonds to other banks and holding bonds issued by other banks which are debt instruments as a constant source of financing their main activity which is making loans.
Liability management is now considered more vulnerable - chiefly to systemic risk - as a result of the 2007 to 2010 Global Financial Crisis (GFC) as it is a widespread globally prevalent convention of banking operations. Some return is now being made toward the asset management methodology which was standard in Australia up until the 1980s whereby, a bank’s loans were funded by the surplus available to the bank above the steady stream of cash in and out-flows due to deposits and withdrawals made by account holders and other bank customers.
One of a bank’s other financing requirements is for the maintenance of its customer service business activities and systems (branches, employees, technology and marketing).
All banks must also maintain inter-bank transfer accounts with the central bank of Australia, the Reserve Bank. The reserve account held with the Reserve Bank must constantly maintain a positive balance. This would increase the need for a highly liquid source of funds to meet the requirement which is available in the form of Commonwealth Government Securities (CGS) issued by the Reserve Bank – the same bonds which set the over-night cash rate.
The Influence of Differences on Financing Decisions, and; Cost-of-capital Decision Making
The fact that banks either must or choose to use debt regularly as a source of liquidity, means that their financial leverage is increased. It is precisely for this reason that the Basel II Accord stipulates a minimum amount of capital is represented by equity – as a counter-measure to reduce risk...