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CAPITAL STRUCTURE (for banks and other fnancial institutions)

Banks hold risks, increasing their (fnancial) leverage increases the probability of incurring the
costs of fnancial distress. Therefore, holding (equity) capital commensurate with the risks on the
banks books is sensible from both an economic and a regulatory point of view and can be
considered as an alternative form of risk management.
!t may be deduced that "risk capital# is the relevant and correct measure for both quantifying
total risk and determining the required amount of capital in banks. !t may also be found that for
practical purposes "economic capital# is a feasible pro$y for risk capital.
%% hypothesis would suggest that a banks capital structure is irrelevant for value creation and
that there is no interconnection between the risk&management actions of a bank and the amount
of equity capital it needs to hold.
'dditionally, the %(% propositions would predict that capital structures should be distributed
randomly across frms and industries. )owever, as can be observed in reality, banks have the
highest leverage of frms in any industry. 's e$emplifed in Table *.+, not only is the capital ratio
of banks e$tremely low, but also fairly consistently so across the sampled ,-, ../. banks in the
si$ selected asset&si0e buckets. 1iven this observation alone, one might be tempted to conclude
that banks basically violate one or more of the %(% assumptions and that, therefore, the capital
structure is relevant for banks and can be used to create value. .nder such conditions, the value
of a bank is a function of its fnancial leverage.
2arious models can be developed that ma$imi0e value by trading various leverage related costs
against leverage&related benefts when determining the optimum where the marginal e3ects
equal out. Typically, the reduced form of such models tries to fnd the optimal capital structure
where the marginal ta$ benefts equal the marginal increase in bankruptcy costs.
4rom table *.+ it is also evident that smaller banks tend to have concentrated ownership and
owner&managers, suggesting that they prefer more risk management to less. /ince they have
only limited access to sophisticated risk management, they need to hold (relatively) more.
'dditionally, other reasons may account for the relatively lower leverage of smaller banks.
/maller banks tend to have5
%ore operating risk due to the lack of management depth
' lack of fee&based income that has a stabili0ing e3ect on the earnings volatility, thus
making risk management less necessary
' lack of diversifcation of their credit portfolios (with geographical and6or industry
concentrations).
4igure *.7, therefore, summari0es economic reality, although the si0e of the various tranches is
not intended to be drawn to scale and is not meant to indicate the actual si0e and split of the
losses borne by the respective stakeholder groups at any bank. )owever, it clearly indicates that
8at one end of the spectrum8for e$ample, insured customers only have to bear the most
e$treme of losses and are only hit in the rare event when their deposits with the bank e$ceed the
insured ma$imum amount. Both the low probability of such an event happening and the small
amount of losses borne by insured depositors are represented in the smallest of tranches in the
far left of 4igure *.7.'t the other end of the spectrum, shareholders always bear all residual
losses and basically provide so&called "credit enhancement#, which they also do in reality
!n reality, however, the di3erent stakeholder groups might not be aware of this sequential loss
taking and do require the bank to hold capital up to the level where they would be hit by losses.
This e$plains, on the one hand, why8looking at the problem from an individual point of view8all
di3erent stakeholder groups have di3erent capital requirements to make their investment
basically risk&free, as has already been indicated. 9n the other hand, from a collective point of
view, all stakeholders are interested in ensuring that the bank holds enough capital so that they
will not be hit by a bank run. This is true because they all have an interest to ensure8that the
bank, by holding enough capital, will be able to operate at the same level of capacity, that is, to
maintain the same level of business and associated proftability.
/ince credit&sensitive customers will only enter into a transaction when they believe that the
bank itself will survive until the contract is due, most of the value of a bank is dependent on the
bank being able to continue operations. The entire bank and its capital8as measured by the
credit standing of the overall bank8back this belief.
Risk Capital is defned as the minimum capital amount that has to be invested to buy insurance
that fully protects the value of a banks net assets against a decline in value, so that completely
default&free fnancing of these net assets can be obtained. :isk capital therefore di3ers from
regulatory capital (which attempts to measure risk capital according to a particular accounting
standard;*) and from cash capital (i.e., up&front cash that is required to e$ecute the transaction
and that is a component of the working capital of a bank).

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