The question in mine and I’d imagine in many others minds is how banks were able to reach the state they did to cause the crash of 2008. Many of the findings lead to the fact banks were lending far too much at a very cheap rate. This choice exposed them to high levels of risk with them lending to people who will more than likely struggle to meet repayments. When this situation arose and the banks were loosing more and more without getting what was needed in return, their debt levels you could say span out of control. With the bank been heavily dependent upon short term debt and with only having to hold 2% of assets against any of their lending, banks like Northern Rock really struggled to cope.
From this realisation, central banks from 27 countries come up with what they deem as fair and necessary - the Basel III agreement. The main purpose of this is that banks are able to cope if they begin to make losses on their loans, it is especially crucial for the SIFI’s (the larger banks) whose failures could bring down the whole financial system, (BBC News, 2011). From this, Reuters (2011) discovered that there may be further regulations put on the SIFI’s to prevent such a crash happening. The biggest rule that will make the most impact and benefits according to the BBC News (2011), is the rules regarding the ‘core capital ratio’, meaning that banks now need to hold 7%, not 2% of their assets against their borrowings. This figure however is not set in stone; the agreement comes with buffers to allow a degree of flexibility. This involves a 2.5% ‘countercyclical buffer’, meaning banks can let the ratio fall to 4.5% temporarily, one could argue that this new regulation is irrelevant if they allow such flexibility, but you need to keep in mind that until the ratio reaches 7% again, bonuses and dividends are limited. This flexibility also goes in the other direction, the ratio can be put up to 9.5% if a ‘boom’ comes around, the banks lending would be restricted further, (Financial Times, 2011).
Although this agreement may seem an ‘ideal’ remedy to the issues in the banking sector, the fact that these and other rules of the Basel III agreement are not coming in to action until 2019, there must be something banks could do till then? How can the banks finance themselves in such a way that won’t affect the economy in the way we have found recently, but can still provide value for their shareholders?
One way is to finance through equity, through the release of shares on to the stock market, which the Wall Street Journal (2011) suggested that Europe may do this or to look in to Venture Capitalists, which they say will “take up any slack”. The traditional view to equity financing sees this method to have high costs slapped on to it. Despite these costs, if a company was to go through a bad year a simple option would to not pay dividends, where as financing through debt during a bad year you still have to make repayments, along with this which we have all seen, comes a high risk of failure. However, Modigliani and Miller (1958) put forward that capital structure does not affect the value of company or shareholder value, with the view that total market value is independent from capital structure. The acceptance of this view was limited within the business world due to the assumptions that came with it, for example ‘no taxation’ and ‘perfect capital markets’ – which we know isn’t true, it is not the case that perfect information is available and that everyone is ‘rational’, the Turner Report 2009 discovered this with the fact that people follow the crowd, or a ‘herd effect’ occurred, proving the lack of rationality of everyone.
With the amount of arguments rising regarding debt financing and equity financing, and whether the traditional view or the view of Modigliani and Miller is true, in my opinion is irrelevant. I feel that having these facts and opinions in place highlights what professionals and academics should be aware of when considering finance and capital structure, which I guess is what the likes of the; FSA, FSB and Basel Committee were taking in to consideration when designing the Basel III agreement?
No comments:
Post a Comment