1 MCF 304: Bank Management Lecture 3.1 Bank’s Capital Management

2 Banks management and the regulatory body are different in their views on bank capital management (LP Dilemma) Regulatory body stipulates various rules such as capital diversification to ensure the security of deposits as well as bank’s stability

3 Bank’s Capital Management On the other hand, the management is more incline to use capital for maximum returns A huge capital base can reduce risks by absorbing income volatility, limiting growth opportunities and reducing the probability of failure However a huge capital base may also reduce the rate of return to shreholders

4 Bank’s Capital Management Bank’s capital can be define as asset minus liabilities and minus certain type of debts and reserves stipulated by regulatory body Debts and reserves are included in bank’s capital in order to ensure capacity adequacy of banks Bank’s core capital can be divided into Tier 1 & Tier 2

5 Bank’s Capital Management Bank’s Capital Tier 1 Ordinary Shares Preference Shares Capital Reserves Unappropriate Profits Contingency Reserves Loan Loss Reserves Debentures Convertible Securities

6 Characteristics of Bank Capital Ordinary shares Preference shares Unappropriated Profits Capital Reserves Contingency Reserves Loan Loss Reserves Debentures Convertible Securities

7 Function’s of Bank Capital Operational function Protection function Supervision function

8 Characteristics of Bank Capital Operational -Long term fund usually consist of shareholder’s fund & long term debt -Normally used to finance fixed assets -Used as a measurement for opening new branch Protection -Act as a loss absorber -Assurance to the general public on the bank’s capability

9 Function’s of Bank Capital Supervision -Requirement by the central bank -All financial institution must have adequate capital base to be allowed to conduct business -A capital base will help bank’s prevent “bank runs” situation when they incurred losses -The banks capital must be able to absorb any losses and ensured the bank’s continued operations

10 Example: ABC Bank Assets Cash10 Short term securities20 Loan & advances100 Fixed assets10 Total140 Liabilities & Equities Deposits60 Long term debts10 Capital40 Retained earnings40 Total140

11 Example: ABC Bank Assets Cash10 Short term securities20 Loan & advances70 Fixed assets10 Total110 Liabilities & Equities Deposits60 Long term debts10 Capital30 Retained earnings10 Total110

12 Example: ABC Bank Assets Cash10 Short term securities20 Loan & advances20 Fixed assets10 Total60 Liabilities & Equities Deposits60 Long term debts10 Capital(10) Retained earnings- Total60

13 Example: ABC Bank Assets Cash30 Short term securities20 Loan & advances70 Fixed assets10 Total80 Liabilities & Equities Deposits60 Long term debts10 Capital10 Retained earnings- Total60

14 Bank’s Capital Management Most of larger banks are able to raise external capital through capital market but smaller banks are only able to raise capital via internal funds in the forms of retained earnings Retained earnings however must be shared with shareholders in the form of dividend This is why statutory requirements are imposed

15 Bank’s Capital Management This has forced banks to limit growth to a certain percentage of retained earnings plus fresh external capital. The minimum capital requirement had forced the bank to use external capital in the form of debts. Hence the change of minimum capital requirement will change the capital structure of a bank

16 Bank’s Capital Management Banks which are unable to procure additional capital will tend to invest in low risk assets Bank that is able to procure additional funds to increase its capital base tends to invest in high risk assets to justify their investments The minimum capital requirement also influences the pricing policy of a bank

17 Thank You! Izdihar Md Daud Post Graduate Centre HP: