The Capital Structures and Financing Requirements of Banks - Assignment Example

Bendigo bank Student name Instructor name Institution Date of submission Table of Contents 2 Introduction 2 Question 1.Discuss how the capital structures and financing requirements of banks differ significantly from most of other companies and industries 4 Response to question two 7 Calculation of weighted average cost of capital 7 Response to question three 10 Factors to be considered by holders of convertible notes in determining whether conversion of warranted 10 Likely effects of conversion of a substantial proportion of convertible notes on company capital structure 11 Response to question four 11 Conclusion 13 References 16 Introduction Most banks provide lending, saving and deposit facilities for the clients in general. The nature of banking provides options for banking services for corporates and individuals in the banking industry. Expansion in the banking industry involves opening of many branches to extend the customer base in the market due to stiff competition. Banks in general raise money through credit creation and charging of interest rates on customer borrowing. Revolution in the banking sector has seen rise of online and phone banking with the widespread use of Automatic Teller Machines for clients. Aggression in the banking industry has led to stiff competition. The Bendigo bank is assumed to undertake buy-back consideration so as to avoid dilution of management in the bank. The board of directors will consider a number of factors in relation to issue of preference of shares or unsecured notes to finance share repurchase. Calculation of current after tax, weighted average cost of capital will determine the influencing decisions for whether to choose preference shares or unsecured notes to finance share repurchase. Issuance of perpetual convertible note will affect buy-back decision of the bank. The holders of convertible notes will easily convert them into ordinary shares and this will dilute the ownership of the bank through outsides owning ordinary shares in the bank. There is a high likelihood of conversion of convertible notes to ordinary shares to ordinary shares in future and this will negate anticipated ownership in the bank. This paper will discuss the factors to consider before issuance of convertible notes is made. This is because issuance of convertible notes will affect the capital structure of a company. Wholesale funding to fund credit growth refers to use of long term and short term credit from international and domestic capital markets. On the other hand retail funding is also referred to as deposit finding. This involves client deposit and subsequent use in the banking sector of Australia. Question 1.Discuss how the capital structures and financing requirements of banks differ significantly from most of other companies and industries Common stock requirement is currently 4.5%. The common equity plus other financial banking instruments is currently at 6%.capital reservation buffer is required to be at 2.5%.this will increase the common share equity to 7%.the role of conservation buffers is to absorb losses during financial crisis. Buffers will assist banks during times of financial stress (Fernando, 2010). Whenever there is regulatory capital ratios approach minimum requirements this will pose constraints on discretionary dividend payouts and bonuses. The cost of funding in the Australia banking sector is likely to be high. This will increase competition in the banking industry. Banks rely on borrowed funds to finance their borrowed loans. Foreign capital markets will finance the cost of funding up to the tune of 28%.the capital structure of Australia banks include domestic deposits, equity, short term wholesome debt, securitization and long term wholesome debt. The bans deposit rates is relatively low and this is approximately 6.0 %( Corcoran, 2013). There are strict regulations in relation to the capital structure disclosure by banks. The standards of disclosure will determine the minimum capital and amount to be loaned out to the clients in the industry. Liquidity will be influenced by number of ordinary shares a bank holds the selling of ordinary shares to outsiders will dilute management of banks and this will influence decision of capital structure in the banking sector. Capital requirements are also referred to as regulatory capital .this is the minimum amount a bank is supposed to hold as a financial regulatory obligation. Capital adequacy ratio expresses capital requirements in a bank. The capital requirements define the portion banks are supposed to hold and not to take excess leverage and in the long run become insolvent. A capital requirement determines the equity to debt ratio for banks (Euro property, 2007). The capital requirements are there to ensure prudence in financial management. This will protect banks from insolvent and customers from banks bail out. The government is the agent of capital requirements in the banking industry. This is because it is liable for deposit insurance cost for banks. Bank failure will collapse the economy and this necessitates need for deposit insurance. The rules ensure that banks hold sufficient amount of capital. There is a legal framework on how bank will settle international settlements. This framework guides calculation of capital for banks and this will decision making between depository institutions and banks. Capital ratio is supposed to be at least 80% for banks. There is a high quality for banking in Australia and this means that capital requirements are not difficult to meet. Global liquidity standards in Australia mean that there is high incidence of meeting stable funding ratio. The limited supply of government securities restricts fiscal government policies in the country. Banks have a third share which relate to short term debt. Most banks preference to long term funding of the capital structures Capital structure involves sources of funds for banks. The common sources of funds for banks include interest rates, customer deposits, borrowing from central banks, interbank borrowing and service charges for custody of legal documents. Banks also own shares in profitable companies and give dividends to the shareholders of their shares. There is allowance for takeover of other banks so as to enhance their market dominance (Barker &Martin, 2007). The capital structure of a bank includes ordinary shares, preference shares, debentures, and asset holding in other companies. Influence of capital structures and financial requirements on importance of their financing and cost of capital decision making Australian banks are very conservative in terms of their lending practices. This is due to robust supervision and bad experience with the world financial crisis. There have low performing loans as compared with other banks in other countries (barker & Martin, 2007). There is rampant use of offshore funding in Australia. This makes Australia banks vulnerable to potential disruptions emanating from global capital markets. Short term debts have declined due to the set banking rates in Australia. Australia banks loss funds through high default rates in the banking industry. This is attributed to the provisions in the mortgage sector for banks. The high banking rates determines the capital ratios for most banks in Australia. The minimum banking rate for most banks is 10%.the Australia average risk weight rate in Australia is two and half times that which is in Canada (barker & Martin, 2007). Prudent lending practices in Australia in relation to capital requirements includes low loan to value ratio and this will bring a sharp decline in asset quality. Instruments of banking regulation in Australia imply to the extent to which banks are related to regulation and this determines capital structure. Capital structure involves the portion of ordinary shares, debentures and preference shares in total sources of funds in the bank. Ordinary shareholders will determine ownership of a banking corporation. This is the factors which will resilience in banks in Australia. There is a high incidence of default rate of Australia banks from the former two percent and this affect disclosure requirement for banks. Response to question two Calculation of weighted average cost of capital The formula for calculation of WACC is given as; Weighted average cost of capital=Weight of capital *cost of equity +weight of Debt *cost of Debt Weighted average cost of capital=782.82206*5.54*.1272=5.51 Unsecured notes=10.5*4*11,241,250=472.1325 Perpetual convertible notes=.008*4*9500000=304…. The Weighted average cost of capital is determined by taking the average of all after tax cost of sources of finance. This is obtained through multiplication of individual source of capital with the relevant weight and then adds the sum of the total multiplication. Weighted average cost of capital refers to the average of capital structure aspects in financing of a capital of a bank. Before banks select to finance its operations using preference shares, it will consider a number of factors. Flexibility of financing plan, the capital market conditions, period of financing, cost of financing, stability of sales and company size. The merit with preference shares is that they can be bought back. Companies are advised to go for issues of debentures and loans as a source of finance. The market price of preference shares will determine the buyout decision. Equity shares are very common in the capital structure of companies during periods of depression. Capital structures influence cost of preference shares in a company. Established bank will be in a position to determine cost of capital and selection of source of capital in the banking industry. When the sales are relatively high, the bank can meet fixed cost such as debenture interests and preference shares dividends. Preference shareholders earn dividends after outside liabilities have been met in the buyout. When the bank sales are unstable, the bank will not be able to meet fixed commitments and this affect capital decisions in the banking industry. In this case, equity shares are the best option to finance the banking decisions. For relatively small companies, retained profits, bank loans and borrowing from other banks will finance major capital decisions of a bank. Preferences shares do don’t affect goodwill of a bank and this determines wife capitalization of banks at a given point in time (Shelters, 2013). The weight average cost of capital will affect buy back decisions as this will determine the proportion feasible to be issues to finance operations of the bank in the banking industry. Weighted average cost of capital=Weight of capital *cost of equity +weight of Debt *cost of Debt The buy-back is source of capital management program. The unsecured notes are seen as uncompetitive source of financing as most of other institutions have sought for alternative financing products to settle financial obligations. The pay-back decision provides an opportunity for investors to of their unsecured notes to sellers and obtains them at a premium. The pay-back price offer is usually is higher than the market price and this means that past performance is not a reliable consideration in decisions relating to indicators of future performance. Bendigo company wants to sell unsecured notes to raise money to stop incidence of bank take over. This is done through repurchase of shares and acquisition of some bank assets. Unsecured notes do not have collateral and it is a risky option to investors. The higher risks attached to them raises the interest rates for the unsecured notes. The board of directors does not need to seek the permission of shareholders so as to make this decision. Use of unsecured notes is similar to issue of poison pill in the shares market. This option is god to thwart hostile takeover as it allow allows existing shareholders to get substantial shares instead of predators of the bank. The unsecured notes will dilute the expected economic value of those planning a takeover of the Bendigo Company. They are usually offered at a relatively low cost to the existing shareholders. The use of unsecured notes is an effective form of preventing hostile takeovers. This is because it dilutes the voting and economic value of shares which will be used by predator and planners of hostile takeover in the market for the bank (Dresner &Kim, 2004). In order to buy back shares of a company, issuance of debentures, and borrowing from other banks is recommended. This is because, during periods of financial depression, preference shares will not adequately cover cost of capital or cost to acquire. Unsecured notes are unattractive to financiers as the size of the bank is relatively small in relation to other banks in the industry. Ordinary shares are not recommended to issue as this will dilute ownership in the bank. Dilutions of ownership will permit initiation of take over decision. The board of directors will risk the financial management and ownership of the bank in the incidence if issuing of ordinary shares to the outsiders of the bank. The decision to repurchase some of the shares will secure the bank from any attempts of repurchasing the company in the future by the major players in the industry. The financial structure will affect the capital structure of the company depending on the shareholding which affects common shares in the banking industry (Shelters, 2013). The only eligible persons to participate in the by-back offer are those note holders who are registered in Australia. The notes which will not be bought back will still be outstanding and participation in the buy-back is a voluntary exercise (Corcoran, 2013). Response to question three Factors to be considered by holders of convertible notes in determining whether conversion of warranted Convertible notes have a maturity time of more than 10 years. After the ten years period, the holders have an opportunity of converting the notes into ordinary shares. Factors to consider include growth potentials and credit rating of the bank. There is a possibility of growth for this bank, and there is need to hold shares in the company and this will prompt conversion of convertible notes into ordinary shares in the bank. Coupon rate of payment will be another factor to be considered by holders of convertible notes. The possibility of conversion of interest cash payment is advantageous to the holders. Vanilla convertible notes grant holders a right to convert them at the prevailing and predetermined prices. They have a fixed maturity date. The holders will redeem the note at the nominal value. Mandatory convertible notes are mandatory to convert upon maturity. There is possibility of risk reversal in relation to option strategy of mandatory convertible notes. Possibility of separate trading of convertible notes will influence decision of convertible notes holders in the banking sector. Dynamism relating to convertible notes will affect decision of holders of convertible notes. Other factors to be considered by the holders of convertible notes include conversion price, issuance premium, conversion ratio, redemption date, final conversion date, coupon and yield of convertible notes at the date of issuance (Bierman, 2003). Likely effects of conversion of a substantial proportion of convertible notes on company capital structure Conversion of a substantial proportion of convertible notes will dilute proportion of ordinary equity in the company. This will prompt possibility of company take over as the capital structure of company will have a high proportion of common shares as related to the proportion of others in the market. The presence of high number of common shareholders will affect the ownership and process of decision making in the company (Bierman, 2003). Conversion will dilute voting rights in the company. This is in the final conversion date in relation to the date of issue. Convertible preference shares also carry voting rights and this will impact on share exchange and conversion aspects in the banking industry. Conversion will increase the debt amount in the company (Fernando, 2010). Response to question four The main cause of 2007 financial crisis is lack of prudent banking sector policies which relied on foreign banking to support the banking industry. The risk associated with the wholesale banking involves increase in the level of foreign debt and unsoundness in the formulation of banking sector policies. Changes which relate to dynamism in the retail banking include international institutions decision to adopt relatively less aggressive options in retail banking. Retail is said to be less aggressive as compared with wholesale banking. Market securitizations is also deteriorating in terms of price and volume and this has prompted the shift from the traditional wholesale banking to the retail banking in the industry and in Australia as a whole. Retail banking invests in innovation and product choice in the banking industry (Euro property, 2007). There is efficiency and stability in the retail banking options. Retail banking is a competitive way of doing banking business. Cost of funds determines ability to secure funds in retail banking. There is systematic importance of engaging in retail banking as it is cost effective in relation to credit rating of relatively small banks (Baker &Martin, 2011). Stiff competition will raise profitability aspect in retail banking. This will relate to effectiveness of competition in the banking sector. Retail banking will concentrate market for banking. There is effective reduction of barriers to entry in the retail banking. Globalization and technology have minimized barriers in retail banking in the recent times and this trend is likely to continue in the near future. This is positive in the retail banking and this is common in relation to the growth aspects in the industry. Technology has minimized distribution costs and there is free entry to retail banking in Australia. Changes in policy and globalizations have attracted overseas banks to enter aggressive competition on the retail banking. Retail banking presents substitutes in the banking industry. There is a wide range of banking product substitutes in the Australian banking industry due to the development in retail banking. This is attributed to the recent development in the Australian banking sector. There is possibility of switching in the bundle of products and individual products due to recent changes in the policy and technological developments (The economist, 2003). Conclusion The common sources of funds for banks include interest rates, customer deposits, borrowing from central banks, interbank borrowing and service charges for custody of legal documents. Banks also own shares in profitable companies and give dividends to the shareholders of their shares. There is allowance for takeover of other banks so as to enhance their market dominance. . The high banking rates determines the capital ratios for most banks in Australia. The minimum banking rate for most banks is 10%.the Australia average risk weight rate in Australia is two and half times that which is in Canada. The government is the agent of capital requirements in the banking industry. This is because it is liable for deposit insurance cost for banks. Bank failure will collapse the economy and this necessitates need for deposit insurance. The rules ensure that banks hold sufficient amount of capital. . Revolution in the banking sector has seen rise of online and phone banking with the widespread use of Automatic Teller Machines for clients. Aggression in the banking industry has led to stiff competition. Australian banks are very conservative in terms of their lending practices. This is due to robust supervision and bad experience with the world financial crisis. There have low performing loans as compared with other banks in other countries (Fernando, 2010). Flexibility of financing plan, the capital market conditions, period of financing, cost of financing, stability of sales and company size. The merit with preference shares is that they can be bought back. Companies are advised to go for issues of debentures and loans as a source of finance. The market price of preference shares will determine the buyout decision. Equity shares are very common in the capital structure of companies during periods of depression. Capital structures influence cost of preference shares in a company. Unsecured notes are unattractive to financiers as the size of the bank is relatively small in relation to other banks in the industry. Ordinary shares are not recommended to issue as this will dilute ownership in the bank. When the sales are relatively high, the bank can meet fixed cost such as debenture interests and preference shares dividends. Preference shareholders earn dividends after outside liabilities have been met in the buyout. When the bank sales are unstable, the bank will not be able to meet fixed commitments and this affect capital decisions in the banking industry. In this case, equity shares are the best option to finance the banking decisions. Dynamism relating to convertible notes will affect decision of holders of convertible notes. Other factors to be considered by the holders of convertible notes include conversion price, issuance premium, conversion ratio, redemption date, final conversion date, coupon and yield of convertible notes at the date of issuance. The holders of convertible notes will easily convert them into ordinary shares and this will dilute the ownership of the bank through outsides owning ordinary shares in the bank. There is a high likelihood of conversion of convertible notes to ordinary shares to ordinary shares in future and this will negate anticipated ownership in the bank. Convertible notes have a maturity time of more than 10 years. After the ten years period, the holders have an opportunity of converting the notes into ordinary shares. Factors to consider include growth potentials and credit rating of the bank. Globalization and technology have minimized barriers in retail banking in the recent times and this trend is likely to continue in the near future. This is positive in the retail banking and this is common in relation to the growth aspects in the industry. Technology has minimized distribution costs and there is free entry to retail banking in Australia. . Retail is said to be less aggressive as compared with wholesale banking. Market securitizations is also deteriorating in terms of price and volume and this has prompted the shift from the traditional wholesale banking to the retail banking in the industry and in Australia as a whole. References Baker, H. K., & Martin, G. S. (2011). Capital Structure & Corporate Financing Decisions: Valuation, Strategy and Risk Analysis for Creating Long-Term Shareholder Value. Chichester: John Wiley & Sons. Bierman, H. (2003). The capital structure decision. Boston, Mass. [u.a.: Kluwer Academic Publ. Business knowledge for IT in global retail banking: The complete handbook for IT professionals. (2011). London: Essvale Corporation. Corcoran, C. M. (2013). 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