Topic 9 - Managing Capital

Question 1

Ideally, the capitalof an ADI should exhibit the following characteristics:

Answer 1

1. Be a permanent commitment of funds
2. Be freely available to absorb losses
3. Not impose unavoidable servicing charges
4. Rank behind the claims of depositors and other creditors in the event of winding up

Question 2

DEFINITION OF CAPITAL

Answer 2

The traditional definition of capital –the one most people think of when they think of the capital of an ADI –is that it is equal to the net worth of the ADI

Question 3

FUNCTIONS OF CAPITAL

Answer 3

One of the most important functions of capital is to absorb losses to protect depositors –this is seen as essential to protect the safety and security of the financial system

A second function of capital is the promotion of confidence for the ADI’s customers

A third function is as a source of investment funding, in the event that the ADI is planning equity investments, takeovers or mergers

Question 4

The ADI can reduce its exposure to capital risk in different ways, but each of those different ways will generally lead to a reduction in return

Answer 4

It can increase the amount of capital, but this will reduce the leverage multiplier and hence the return on equity 
It can reduce the risk of loss by reducing the value of assets, but this will reduce the amount of return 
It can reduce the risk of loss by investing in less risky assets, but this will reduce return because less risky assets usually generate a lower rate of return

Question 5

The optimal amount of capital needs to be small enough to allow for an adequate return on equity, but large enough to:

Answer 5

Maintain capital risk at an acceptable level 
Be reasonably consistent with peer institutions 
Be acceptable to ratings agencies 
Comply with regulatory requirements

Question 6

There are five steps that should be undertaken as part of the process of planning to meet the capital target

Answer 6

1. Analyse current performance
2. Predict key variables
3. Determine the target level of capital
4. Project and assess planning targets
5. Modify plans to achieve the target

Question 7

All else being equal, Internal growth is more likely to be sustainable if:

Answer 7

Capital targets are low 
Anticipated profit is high 
The retention ratio is high

Question 8

retention ratio

Answer 8

The retention ratiois the proportion of profits retained with a firm, rather than being paid out as dividends

Question 9

The higher the retention ratio

Answer 9

The higher the retention ratio, the greater the level of growth that can be financed internally, thus avoiding the cost of raising external finance

Question 10

Ideally,whatarethefourcharacteristicsofADIcapital?

Answer 10

Ideally, ADI capital should be a permanent commitment of funds, attract no unavoidablecharges,beavailabletoabsorblossesandrankbehindclaimsof depositorsandothercreditorsintheeventofwindingup.

Question 11

Withthesecharacteristicsinmindexplainwhybankprudentialsupervisorsdecided toseparatecapitalintotwotiers,useexamplesofdifferentsourcesofcapitalto illustrateyouranswer

Answer 11

Somefundingsuchasissuedsharesandretainedprofitsclearlyhasallthreeof thesecharacteristicsbutothershavesomebutnotallofthesecharacteristics.Tier 1capitaliscomprisedofitemsthathaveallthecharacteristics.Tier2capital includesitemswhichpossesssomebutnotallofthesecharacteristics,suchas generalprovisionsfordoubtfuldebt,assetrevaluationreservesandcumulative irredeemablepreferenceshares

Question 12

DescribehowanADIwoulddetermineitscapitalneedsfromitsoverallfinancialplan.

Answer 12

AnADImustsatisfyregulatorycapitalrequirements,withinthisconstraintADIcapital managementshouldbeaimedatmaximisingshareholdervalue.Thismeansthatcapital needsmustreflecttherisk‐returntrade‐off.AnADI’sfinancialplanincludesprojected levelsofassetandliabilitygrowthandassociatedrisksandreturns. Anoveralltargetcapitalpositionisselectedwhichwilloptimiseshareholdervalue.Within theADI,capitalisthenallocatedtodifferentlinesofbusinessdependingonthelevelof risk.Effectiveallocationofcapitalamongdifferentlinesofbusinessallowsforariskadjusted measure of the performance of each line and its contribution to overall performance.Socapitalneedscanalsobedeterminedfromanaggregationofcapital needs of each separate line of business. Management must reconcile these three approachesindetermininganADI’scapitalneeds.

Question 13

Distinguishbetweencreditriskandmarketrisk.

Answer 13

Creditriskistheriskthatacounterpartywillnotmakepaymentsinfull,ontime andaccordingtothetermsofthefinancialcontract.Marketriskisconcernedwith thepossibilityofincurringlossesduetofluctuationsininterestrates,equityprices, commoditypricesandexchangerates.

Question 14

Whatarethethreevariablesthatdeterminetheinternallysustainablegrowthrateofan ADI?

Answer 14

TheinternallysustainablegrowthrateofanADIdependsonthetargetlevelofcapital,the ADI’sprofitabilityandtheproportionofprofitsretainedbytheADI.

Question 15

WhatfactorsshouldmanagementtakeintoaccountwhendetermininganADI’sdividend policy?

Answer 15

WhendetermininganADI’sdividendpolicymanagementmusttakeaccountofthesignals itissendingtothemarket,andtheincomeexpectationsofshareholders.

Question 16

IfinternallygeneratedcapitalisinsufficienttosupportanADI’splannedassetgrowth, whatalternativesareopentomanagementinordertoachievethetargetlevelofcapital?

Answer 16

IfanADIfacesapotentialcapitalshortageitmay:  Slowtheplannedgrowthofassets  Decreasetheriskmixofassets  Increaseinternalgenerationofcapital  Raiseexternalcapital

Question 17

Outlinetheadvantagesanddisadvantagesofthethreemaincategoriesofexternalcapital sourcesforanADI.

Answer 17

The three main categories of external capital sources for an ADI are: ordinary shares, preferencesharesandsubordinateddebt.Broadly,theadvantagesofordinarysharesarelower risks,lowervariabilityofearningspershare,andlowerprobabilityofinsolvency.Ontheother hand, debt and preference shares also haveadvantagessince theycause lessdilution of earningspersharethanordinarysharesand,totheextentthatthedividendorinterestcostof preferencesharesanddebtislower,earningsperordinarysharearegreater.

Question 18

ordinary shares

Answer 18

The most common type of external capital is ordinary shares Ordinary shares rank behind all other claimants in their right to receive dividends or the distribution of net assets if the ADI is liquidated Because the claim of ordinary shareholders is a residual claim, dividends can be highly variable

Question 19

There are several ways in which ordinary shares can be issued

Answer 19

public offer
private placement
rights issue

Question 20

public offer

Answer 20

In a public offer, the public is invited to subscribe for newly-issued shares
This method gives the ADI access to a large amount of capital, but it can be expensive, and tends to dilute the shareholding of existing shareholders if they do not subscribe

Question 21

private placement

Answer 21

a large (usually institutional) investor is offered a large parcel of shares

Question 22

rights issue

Answer 22

existing shareholders are given the right to buy new shares on a pro-rata basis to their existing holding

Question 23

preference shares

Answer 23

Preference shareholders rank ahead of ordinary shareholders, but behind all other claimants 
The dividend amount is usually fixed as a percentage of the issue price 
Preference shares do not mature, although sometimes they are redeemableat the option of the issuing company or the shareholder 
Dividends could be cumulative, which means that dividends missed in one year are paid in future years

Question 24

Subordinated debt

Answer 24

Subordinated debt may be in the form of corporate bonds or long-term loans

Question 25

senior capital

Answer 25

due to their higher ranking, preference shares and subordinated debt are referred to as senior capital

Question 26

Ideally,whatarethefourcharacteristicsofADIcapital?

Answer 26

Ideally, ADI capital should be a permanent commitment of funds, attract no unavoidablecharges,beavailabletoabsorblossesandrankbehindclaimsof depositorsandothercreditorsintheeventofwindingup

Question 27

Withthesecharacteristicsinmindexplainwhybankprudentialsupervisorsdecided toseparatecapitalintotwotiers,useexamplesofdifferentsourcesofcapitalto illustrateyouranswer

Answer 27

Somefundingsuchasissuedsharesandretainedprofitsclearlyhasallthreeof thesecharacteristicsbutothershavesomebutnotallofthesecharacteristics.Tier 1capitaliscomprisedofitemsthathaveallthecharacteristics.Tier2capital includesitemswhichpossesssomebutnotallofthesecharacteristics,suchas generalprovisionsfordoubtfuldebt,assetrevaluationreservesandcumulative irredeemablepreferenceshares.