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Equity Capital in Banks – Why is it Important?

In light of the recent turmoil in banking, investors are questioning whether this economy is back on track to produce meaningful growth in 2010. Our banking system has faced much scrutiny and even though much of the public has great distaste for the way banks have been run and managed, I will express my view that we cannot sustain productive growth while lending – both business and consumer – is still extremely tight. The latest consensus is that lending standards will become even tighter in 2010, which will have a ripple effect through domestic commerce.

I think few realize why banks – the same folks who loosened lending standards and took on unreasonably high risk – would be so stingy. After all, isn’t a bank’s fundamental business harvesting deposits and lending money? Especially in a steep yield-curve environment with cash rates close to zero, lending should be quite profitable. The answer for the current environment has much to do with the importance of how and why banks are required to maintain equity capital.

To begin, equity capital is a component of all businesses, not just banks. Equity capital is often the most expensive funding mechanism in a corporation’s capital structure and can be generated either through issuing equity to shareholders or retaining earnings. The nature of the banking business makes maintaining adequate levels of equity capital crucial and current guidelines were promulgated during the Basil accords in 1998. The reason why banks are distinct from other industries is primarily because bank assets are intangible – the asset side of a bank’s balance sheet is comprised of loans and securities, not inventories and accounts receivable, as is common in more traditional businesses. As well, the pure financial nature of the banking environment and the breadth of reach throughout the global economy necessitates restrictions.

Here is a very simple example of a bank’s balance sheet:

Bal Sheet

Issuing and holding loans is generally more profitable than owning securities, so banks prefer to maintain a much higher percentage of loans than securities on their balance sheet – and therefore earn more interest. Loans are also higher risk. This combination was the main reason that the sector faced an unprecedented liquidity crunch last fall. The market value of loan assets was dropping because there was not a liquid market to value or trade the loans. As a result, many banks could not meet daily funding requirements and others needed to take enormous write-downs to compensate for the loss in loan values. The most basic balance sheet equation is total assets must equal liabilities plus equity and therefore most of the write-downs went straight to equity, as the value of the liabilities was largely unchanged. Fundamentally, equity is the margin by which creditors will be covered if a bank’s assets were liquidated. As this margin is diminished, a bank’s borrowing cost gets much higher. As well, if equity capital is depleted, a bank’s liabilities become greater than the value of their assets and they are insolvent.

Understanding this relationship gives an insight into why lending is still significantly constrained. Banks still have billions of dollars in loans on their balance sheets – mortgages, for example, are long-duration assets and will be around until they payoff (through a home sale, refinance, or complete paydown of principal), are sold, or are charged-off as delinquent. Given their exposure to weak consumer and corporate credit, banks currently view the risk of providing new loans to be too high and they will have to reserve more in equity capital to offset this risk. The secondary market for selling loans has still not fully recovered, so the ability to reduce this burden through loan sales is difficult. Banks are better suited to retain cheap liabilities (deposits) and generate earnings through current channels as a cheaper way of building back equity capital. The speculation around raising the minimum equity capital requirements doesn’t help. This action would only further restrain lending as you can see from the above relationship. Maintaining adequate capitalization levels is crucial for a healthy banking system, yet will continue to constrain business and consumer credit until the environment stabilizes and the risk/reward tradeoff of lending becomes profitable again.

Disclosure: Disclosure: None