Introduction to Bank Recapitalization

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Introduction to Bank Recapitalization
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  Introduction to Bank Recapitalizationby Iakovos Alhadeff  Published by Iakovos Alhadeff at SmashwordsCopyright 2014 Iakovos Alhadeff   Table of Contents IntrodutionA !anking "#ample with $eapitali%ation&ow $eapitali%ation 'akes PlaeA !anking "#ample with (i)uidity Crisis'he real world  Introduction After the eonomi risis of 200*+ and the banking risis that followed+ we have all heard hundreds of times the e#pression ,banking reapitali%ation-. !eause most  people do not know how banks work+ populists have e#tensively used the banking industry in order to disorient the publi+ and ahieve politial benefits for themselves. 'he way they do so+ is by telling the innoent and ignorant on the sub/et people+ that the government gives lots of money to the bankers instead of giving it to the poor. In this essay+ I want to e#plain in very simple words what we mean by bank reapitali%ation+ and how this takes plae+ so that everybody understands what it really is. I will use an e#ample that I used in my essay ,'he &ousing !ubble and the !anking Crisis for non "onomists-+ and modify it+ in order to plae the emphasis on the issue of bank reapitali%ation. I might add some aounting omments i.e. about  balane sheets et+ but people who are not at all familiar with aounting an skip these omments+ and still be able to understand everything. A Banking Example ith Recapitalization (ets assume that I want to open a bank. I put down 120 million euros in share apital in order to do so. 'he amount of 120 euros is arbitrary+ as will be all the figures I will use. So I put down 120 euros. 'he money goes in the newly opened banks vault+ and I get paper shares3 for 120 million euros in the banks balane sheet the 120 euros will appear as ash on the asset side and as share apital on the liabilities side3. 'he shares that I will get will be traded in the stok market. 'heir prie goes up when the bank makes profits+ and people have faith in the bank and want to buy its shares+ and goes down when the bank makes losses+ and nobody wants to buy them+ and everybody wants to sell them instead. And for the moment I am holding all the shares. 'herefore for the moment the bank is only funded with apital from its owners me and the share apital I ontributed3. 'herefore the bank finanes its ativities+ mainly loans+ with its own apital. !ut as time goes by+ the bank will reeive apital from outsiders not the shareholders3. 'he obvious soures of e#ternal funding are deposits and borrowing. ou an deposit 1 million euros+ and the bank an use it to make loans. 5r the bank an issue a 1 million bond+ and you an buy the bond thus lending the bank 1 million. 'he bank an again use this 1 million to make loans.!anking regulations re)uire that some of the apital with whih a bank finanes its ativities omes from its owners shareholders3+ and that this apital own apital3 does not fall below a given perentage of total apital. (ets suppose that regulation re)uires that own apital does not fall below 206 arbitrary figure3 of total apital. Imagine a bank with 100 million of shareholder owners3 apital+ whih has also taken deposits of 100 millions+ and has issued bonds borrowed3 another 100 millions. 'his totals to 700 million euros of apital 100810081003+ and if banking regulation re)uires that own apital does not fall below 206 of total apital everything is fine+ sine own apital is 1009700:776 of total apital. It is very reasonable to e#pet banks to have a part of their apital in the form of share apital own apital3+ in order to make sure they are prudent. If I have a bank  that is only finaned through deposits and borrowing+ I an take e#essive risks+ sine even if the bank goes down I will not lose anything. 5n the other hand if some part of the banks apital is my apital shareholder apital3+ and the bank goes down+ I will lose my apital. And therefore I am more autious in my management. So+ there are 7 main soures that banks an use to finane their operations i.e. shareholder apital+ deposits and borrowing. And banking regulations re)uire that own apital shareholder apital3+ does not fall below a given perentage of total apital as I already said. It an be more than that perentage+ but not less than that. If the shareholder apital as a perentage of total apital falls below that perentage+ the  bank goes bankrupt and it is li)uidated. In my essay I will arbitrarily set that  perentage to be 206 of total apital i.e. share apital3 9 share apital 8 deposits 8  borrowing3 must be greater or e)ual to 206. An arbitrary figure I repeat. I must also add that banks an mainly borrow from other banks inter;bank market3+ from the entral bank+ or diretly from the publi by issuing bonds.  <ow lets ome bak to my e#ample. $emember I opened a bank with 120  euros.  <ow I also take a deposit of 100 euros from a rih ustomer. <ow the bank has in its vault 220 euros+ whih are finaned ==6 by share apital 1203+ and 4=6 by deposits 1003. <ow the bank also issues bonds+ and borrows from the publi another 100 euros. <ow the bank has in its vaults 720 euros+ whih are finaned 7>.=6 by share apital 1203+ 71.2=6 by deposits 1003+ and 71.2=6 by  borrowing 1003. 'he bank has not yet issued any loans or performed any other ations it has a balane sheet with 720 ash on the asset side+ and 120 share apital+ 100 deposits+ 100 debt bonds3 in the liabilities side3. "verything is aording to the banking regulations. Share apital is 7>.=6 of total apital+ whih is 1>.=6 more than the minimum level of 206. Assetsillions(iabilitiesillionsCash720Share Capital120!onds Issued100?eposits100 Total!"#!"#  <ow the bank wants to make a loan of 1=0 million euros to a businessman who wants to buy a big building worth 1=0. @e are in 200* before the risis. So the bank issues a loan of 1=0 millions and the businessman buys the building whih also serves as ollateral for the loan. <othing has hanged in the liabilities side of the bank. Capital still stands at 720+ with 120 share apital+ 100 borrowing bonds3 and 100 deposits. !ut on the asset side+ the bank has only 1>0 euros in ash+ and 1=0 in loans. 'his is not a problem+ sine the loan has a value of 1=0 euros. 'he  bank an onfisate the building if the businessman does not pay his monthly instalments+ and reeive its 1=0 in ash. If the businessman meets his obligations+ it will be even better for the bank sine it will reeive its money plus interest.  Assetsillions(iabilitiesillionsCash1>0Share Capital120 (oans1=0!onds Issued100?eposits100 Total!"#!"#  So far+ so good.!ut at the end of 200* there is a huge eonomi risis. 'he businessman leaves the ountry and the bank is left with the building. (ets assume for simpliity that the  businessman has not paid anything to the bank yet. !eause of the risis+ the  buildings value has fallen to =0 euros. (osses are always inurred by the shareholders and not by depositors and lenders+ sine the former are the owners of the  bank. 'hat is as long as there is shareholders apital. !ut in our ase there is suffiient shareholder apital against whih the losses an be written off. In aounting terms+ the loss of the 100 euros+ will go to the profit and loss aount+ and will appear as a negative number at the liability side of the balane sheet+ thus reduing shareholders apital by 100 euros. 'herefore at year end+ the bank has 1>0 euros ash in its vault+ and a building worth =0 euros. 'hats the asset side of the balane sheet. And at the liability side+ the bank has 20 shareholders apital+ 100 borrowing bonds3 and 100 deposits. <ow the 100 loss from the redution in the buildings value has been taken off+ both from the buildings value as an asset3+ and from the shareholders apital at a part of the banks apital at the liability side3. 'he situation is presented in the following table.Assetsillions(iabilitiesillionsCash1>0Share Capital20 (oans=0!onds Issued100?eposits100 Total""#""# ?ont get onfused by the aounting. Simply see the above eonomi event as a loss for the owners. 'he owners made a loan of 1=0 euros+ the borrower ould not pay  bak+ the bank onfisated his building+ whih however has a value of only =0 million euros+ and therefore there was a loss of 100 euros. 'herefore the owners wealth is redued by 100 euros. 'herefore only 20 120 initial offering; 100 loss3 of shareholder apital is left. ou an look at it in this simple way if you are onfused with the aounting. It makes no differene at all. 'he aounting simply reords this loss in the banks books. !ut the loss has nothing to do with aounting. It is a real
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