funded by equity capital. Maintaining equity capital equal to 5 % of assets as in Table 2.2 is more reasonable. Note that equity and subordinated long-term debt are both sources of capital. Equity provides the best protection against adverse events. (In our example, when the bank has $5 million of equity capital rather than $1 million it stays solvent and is unlikely to be liquidated.) Subordinated long-term debt-holders rank below depositors in the event of default, but subordinated debt does not provide as good a cushion for the bank as equity because it does not prevent the bank's insolvency.
As we shall see in Chapters 15 to 17, bank regulators have tried to ensure that the capital a bank keeps is sufficient to cover the risks it takes. The risks include market risks, credit risks, and operational risks. Equity capital is categorized as “Tier 1 capital” while subordinated long-term debt is categorized as “Tier 2 capital.”
2.3 DEPOSIT INSURANCE
To maintain confidence in banks, government regulators in many countries have introduced guaranty programs. These typically insure depositors against losses up to a certain level.
The United States with its large number of small banks is particularly prone to bank failures. After the stock market crash of 1929 the United States experienced a major recession and about 10,000 banks failed between 1930 and 1933. Runs on banks and panics were common. In 1933, the United States government created the Federal Deposit Insurance Corporation (FDIC) to provide protection for depositors. Originally, the maximum level of protection provided was $2,500. This has been increased several times and became $250,000 per depositor per bank in October 2008. Banks pay an insurance premium that is a percentage of their domestic deposits. Since 2007, the size of the premium paid has depended on the bank's capital and how safe it is considered to be by regulators. For well-capitalized banks, the premium might be less than 0.1 % of the amount insured; for under-capitalized banks, it could be over 0.35 % of the amount insured.
Up to 1980, the system worked well. There were no runs on banks and few bank failures. However, between 1980 and 1990, bank failures in the United States accelerated with the total number of failures during this decade being over 1,000 (larger than for the whole 1933 to 1979 period). There were several reasons for this. One was the way in which banks managed interest rate risk and we will talk about that in Chapter 9. Another reason was the reduction in oil and other commodity prices which led to many loans to oil, gas, and agricultural companies not being repaid.
A further reason for the bank failures was that the existence of deposit insurance allowed banks to follow risky strategies that would not otherwise be feasible. For example, they could increase their deposit base by offering high rates of interest to depositors and use the funds to make risky loans. Without deposit insurance, a bank could not follow this strategy because their depositors would see what they were doing, decide that the bank was too risky, and withdraw their funds. With deposit insurance, it can follow the strategy because depositors know that, if the worst happens, they are protected under FDIC. This is an example of what is known as moral hazard. We will talk about moral hazard further in Chapter 3. It can be defined as the possibility that the existence of insurance changes the behavior of the insured party. The introduction of risk-based deposit insurance premiums has reduced moral hazard to some extent.
During the 1980s, the funds of FDIC became seriously depleted and it had to borrow $30 billion from the U.S. Treasury. In December 1991, Congress passed the FDIC Improvement Act to prevent any possibility of the fund becoming insolvent in the future. Between 1991 and 2006, bank failures in the United States were relatively rare and by 2006 the fund had reserves of about $50 billion. However, FDIC funds were again depleted by the banks that failed as a result of the credit crisis that started in 2007.
2.4 INVESTMENT BANKING
The main activity of investment banking is raising debt and equity financing for corporations or governments. This involves originating the securities, underwriting them, and then placing them with investors. In a typical arrangement a corporation approaches an investment bank indicating that it wants to raise a certain amount of finance in the form of debt, equity, or hybrid instruments such as convertible bonds. The securities are originated complete with legal documentation itemizing the rights of the security holder. A prospectus is created outlining the company's past performance and future prospects. The risks faced by the company from such things as major lawsuits are included. There is a “road show” in which the investment bank and senior management from the company attempt to market the securities to large fund managers. A price for the securities is agreed between the bank and the corporation. The bank then sells the securities in the market.
There are a number of different types of arrangement between the investment bank and the corporation. Sometimes the financing takes the form of a private placement in which the securities are sold to a small number of large institutional investors, such as life insurance companies or pension funds, and the investment bank receives a fee. On other occasions it takes the form of a public offering, where securities are offered to the general public. A public offering may be on a best efforts or firm commitment basis. In the case of a best efforts public offering, the investment bank does as well as it can to place the securities with investors and is paid a fee that depends, to some extent, on its success. In the case of a firm commitment public offering, the investment bank agrees to buy the securities from the issuer at a particular price and then attempts to sell them in the market for a slightly higher price. It makes a profit equal to the difference between the price at which it sells the securities and the price it pays the issuer. If for any reason it is unable to sell the securities, it ends up owning them itself. The difference between the two arrangements is illustrated in Example 2.1.
EXAMPLE 2.1
A bank has agreed to underwrite an issue of 50 million shares by ABC Corporation. In negotiations between the bank and the corporation the target price to be received by the corporation has been set at $30 per share. This means that the corporation is expecting to raise 30 × 50 million dollars or $1.5 billion in total. The bank can either offer the client a best efforts arrangement where it charges a fee of $0.30 per share sold so that, assuming all shares are sold, it obtains a total fee of 0.3 × 50 = $15 million. Alternatively, it can offer a firm commitment where it agrees to buy the shares from ABC Corporation for $30 per share.
The bank is confident that it will be able to sell the shares, but is uncertain about the price. As part of its procedures for assessing risk, it considers two alternative scenarios. Under the first scenario, it can obtain a price of $32 per share; under the second scenario, it is able to obtain only $29 per share.
In a best-efforts deal, the bank obtains a fee of $15 million in both cases. In a firm commitment deal, its profit depends on the price it is able to obtain. If it sells the shares for $32, it makes a profit of (32 − 30) × 50 = $100 million because it has agreed to pay ABC Corporation $30 per share. However, if it can only sell the shares for $29 per share, it loses (30 − 29) × 50 = $50 million because it still has to pay ABC Corporation $30 per share. The situation is summarized in the table following. The decision taken is likely to depend on the probabilities assigned by the bank to different outcomes and what is referred to as its “risk appetite” (see Section 27.1).
When equity financing is being raised and the company is already publicly traded, the investment bank can look at the prices at which the company's shares are trading a few days before the issue is to be sold as a guide to the issue price. Typically it will agree to attempt to issue new shares at a target price slightly below the current price. The main risk then is that the price of the company's shares will show a substantial decline before the new shares are sold.
IPOs
When the company wishing to issue shares is not publicly traded, the share issue is known as an initial public offering
