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Regulators are butting heads with banks this week over capital, with new rules on the table that could force banks to hold more of it. But what exactly is capital, and why is it so important?
The question gets at the heart of the state of finance today. In the crisis, a lack of capital brought some banks to the brink. Now, by requiring banks to bolster their capital, the government is trying to eliminate the need for taxpayer bailouts in the future.
Though capital is a centerpiece of Wall Street regulation, it resists a simple definition. Capital is often described as a cushion that banks hold against losses. That’s true, but the implications are not always clear. One unfortunate misconception that can arise is that capital is a “rainy day fund.”
To understand capital, think about how a financial firm does business. In a typical transaction, a firm makes an investment, and it pays for that investment with a combination of debt and equity. The more debt, or leverage, that finances the transaction, the more money the firm can make (or lose).
Say a firm pays for its investments with nine parts borrowing and one part equity. The firm cares about the return it makes on its equity. By using debt, it can magnify that return.
This is a principle banks use when determining how to finance their operations.
A bank’s capital is analogous to equity in the above example. More capital (so, less debt) means banks are more able to withstand losses. But it also means they can’t make as much money. This dynamic – more capital leading to lower returns – helps explain why banks tend to argue that holding more capital is “expensive.”
But even banks won’t deny that capital is essential. Without it, the tiniest loss would put a bank out of business. Think about capital this way: It designates the percentage of assets that a bank can stand to lose without becoming insolvent. If a bank’s assets decline in value, it has to account for that by adjusting the source of financing that it used. Liabilities like debt and deposits can’t be reduced, as they represent money that the bank has promised to pay to bondholders or depositors. But what’s useful about capital is that it can be reduced, or written down. That’s the whole point. Shareholders, who contribute to capital, agree to absorb losses if the bank falls on hard times.
So, rather than a “rainy day fund,” capital is a measure of a bank’s potential to absorb losses.
How does a bank increase its capital? There are few ways to do this, none of which banks particularly love. One is for banks to retain more of their profit, and not pay it out as dividends or spend it on share buybacks.Another is to sell more shares in the market. That’s generally unappealing to banks because the shares would likely be sold at a discount, and the slug of new shares could cause other shareholders to have their ownership stakes diluted. A third method is reducing assets. This doesn’t actually increase the nominal level of capital. But it does increase ratio of capital to assets, which is one way that regulators measure the adequacy of a bank’s capital. If banks sell some of the things they own, that can have the effect of bolstering capital ratios.
When banks threaten to reduce lending or sell assets if they are forced to raise capital, this is the dynamic they are referring to. The issue is complicated enough as it is, without the political posturing that is taking place. As regulators tinker with the rules, an understanding of capital will help reveal what’s at stake.
A New York Times articles cited on Bloomberg - 10th July 2013.
What Exactly Is Bank Capital, And Why Is It So Important?
Thursday, July 18, 2013
Wednesday, July 17, 2013
Tuesday, July 16, 2013
I was dusting some old news letters and came across one from Seth Klarman (SK), dated 2005, on Risk. I thought to post some very interesting write-up from one of the greatest value investors of all time.
What is Investment Risk? People tend to get confused between Volatility and Risk.
According to Seth Klarman “Volatility is not the same thing as risk. When people do try to measure investment risk, they typically assess the historic volatility of an investment compared to that of the overall market (known as beta).” A common-sense view of risk however should be “how much one can lose and the probability of losing it.”
The father of Value Investing, Benjamin Graham, writes, “The essence of investment management is the management of RISKS, not the management of RETURNS. If one manages the downside the upside will take care of itself.”
“When conditions are generally benign, with markets perhaps even shrugging off bad news, investors tend to forget just how much they can lose and are lulled into sleeping well when they should be tossing and turning. Risk moves to the forefront of investor consciousness only when things are already going badly.” SK
Most money managers face significant pressure to generate return in the shorter term, but it is “crucial to remember that to succeed at investing, you have to be around at the finish.” SK
It’s easy to proclaim your performance in a rising market but one “only find out who is swimming naked when the tide goes out.” Warren Buffett.
Ben Inker, head of asset allocation at GMO once stated that “if one has to outperform, he/she will have to take a risk of looking like an idiot.” i.e. to look for stocks that have underperformed the broader market and for those stocks that the market dislikes. "This increases the risk of getting fired."
Look like an idiot and stop dodging short term gains. Instead, focus your energy for long term returns.
This is a re-post of an article written in 2011.
This is a re-post of an article written in 2011.
What is Investment Risk?
Monday, July 15, 2013
Sunday, July 14, 2013
Tuesday, July 9, 2013
Tuesday, June 14, 2011
Monday, June 13, 2011
Friday, June 10, 2011
Sunday, June 5, 2011
Historically June has been quite lucky for KSE unlike May
Saturday, June 4, 2011
What awaits in the month of June for the Indian market?
What awaits in the month of June for the US market?