Bank Recapitalization

Introduction to Bank Recapitalization

Iakovos Alhadeff

Table of Contents

Introduction

A Banking Example with Recapitalization

How Recapitalization Takes Place

A Banking Example with Liquidity Crisis

The real world

Introduction

After the economic crisis of 2008, and the banking crisis that followed, we have all heard hundreds of times the expression “banking recapitalization”. Because most people do not know how banks work, populists have extensively used the banking industry in order to disorient the public, and achieve political benefits for themselves. The way they do so, is by telling the innocent and ignorant on the subject people, that the government gives lots of money to the bankers instead of giving it to the poor.

In this essay, I want to explain in very simple words what we mean by bank recapitalization, and how this takes place, so that everybody understands what it really is. I will use an example that I used in my essay “The Housing Bubble and the Banking Crisis for non Economists”, and modify it, in order to place the emphasis on the issue of bank recapitalization. I might add some accounting comments i.e. about balance sheets etc, but people who are not at all familiar with accounting can skip these comments, and still be able to understand everything.

A Banking Example with Recapitalization

Let’s assume that I want to open a bank. I put down 120 million euros in share capital in order to do so. The amount of 120M euros is arbitrary, as will be all the figures I will use. So I put down 120M euros. The money goes in the newly opened bank’s vault, and I get paper (shares) for 120 million euros (in the bank’s balance sheet the 120M euros will appear as cash on the asset side and as share capital on the liabilities side).

The shares that I will get will be traded in the stock market. Their price 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. Therefore for the moment the bank is only funded with capital from its owners (me and the share capital I contributed). Therefore the bank finances its activities, mainly loans, with its own capital. But as time goes by, the bank will receive capital from outsiders (not the shareholders). The obvious sources of external funding are deposits and borrowing. You can deposit 1 million euros, and the bank can use it to make loans. Or the bank can issue a 1 million bond, and you can buy the bond thus lending the bank 1 million. The bank can again use this 1 million to make loans.

Banking regulations require that some of the capital with which a bank finances its activities comes from its owners (shareholders), and that this capital (own capital) does not fall below a given percentage of total capital. Let’s suppose that regulation requires that own capital does not fall below 20% (arbitrary figure) of total capital. Imagine a bank with 100 million of shareholder (owners’) capital, which has also taken deposits of 100 millions, and has issued bonds (borrowed) another 100 millions. This totals to 300 million euros of capital (100+100+100), and if banking regulation requires that own capital does not fall below 20% of total capital everything is fine, since own capital is 100/300=33% of total capital.

It is very reasonable to expect banks to have a part of their capital in the form of share capital (own capital), in order to make sure they are prudent. If I have a bank

that is only financed through deposits and borrowing, I can take excessive risks, since even if the bank goes down I will not lose anything. On the other hand if some part of the bank’s capital is my capital (shareholder capital), and the bank goes down, I will lose my capital. And therefore I am more cautious in my management.

So, there are 3 main sources that banks can use to finance their operations i.e. shareholder capital, deposits and borrowing. And banking regulations require that own capital (shareholder capital), does not fall below a given percentage of total capital as I already said. It can be more than that percentage, but not less than that. If the shareholder capital as a percentage of total capital falls below that percentage, the bank goes bankrupt and it is liquidated. In my essay I will arbitrarily set that percentage to be 20% of total capital i.e. (share capital) / (share capital + deposits + borrowing) must be greater or equal to 20%. An arbitrary figure I repeat. I must also add that banks can mainly borrow from other banks (inter-bank market), from the central bank, or directly from the public by issuing bonds.

Now let’s come back to my example. Remember I opened a bank with 120 M euros. Now I also take a deposit of 100M euros from a rich customer. Now the bank has in its vault 220M euros, which are financed 55% by share capital (120M), and 45% by deposits (100M). Now the bank also issues bonds, and borrows from the public another 100M euros. Now the bank has in its vaults 320M euros, which are financed 37.5% by share capital (120M), 31.25% by deposits (100M), and 31.25% by borrowing (100M). The bank has not yet issued any loans or performed any other actions (it has a balance sheet with 320M cash on the asset side, and 120M share capital, 100M deposits, 100M debt (bonds) in the liabilities side). Everything is according to the banking regulations. Share capital is 37.5% of total capital, which is 17.5% more than the minimum level of 20%.

Assets Millions Liabilities MillionsCash 320 Share

Capital120

Bonds Issued

100

Deposits 100Total 320 320

Now the bank wants to make a loan of 150 million euros to a businessman who wants to buy a big building worth 150M. We are in 2008 before the crisis. So the bank issues a loan of 150 millions and the businessman buys the building which also serves as collateral for the loan. Nothing has changed in the liabilities side of the bank. Capital still stands at 320M, with 120M share capital, 100M borrowing (bonds) and 100M deposits. But on the asset side, the bank has only 170M euros in cash, and 150M in loans. This is not a problem, since the loan has a value of 150M euros. The bank can confiscate the building if the businessman does not pay his monthly instalments, and receive its 150M in cash. If the businessman meets his obligations, it will be even better for the bank since it will receive its money plus interest.


Capital120

Loans 150 Bonds Issued

100


So far, so good.

But at the end of 2008 there is a huge economic crisis. The businessman leaves the country and the bank is left with the building. Let’s assume for simplicity that the businessman has not paid anything to the bank yet. Because of the crisis, the building’s value has fallen to 50M euros. Losses are always incurred by the shareholders and not by depositors and lenders, since the former are the owners of the bank. That is as long as there is shareholders’ capital. But in our case there is sufficient shareholder capital against which the losses can be written off.

In accounting terms, the loss of the 100M euros, will go to the profit and loss account, and will appear as a negative number at the liability side of the balance sheet, thus reducing shareholders’ capital by 100M euros. Therefore at year end, the bank has 170M euros cash in its vault, and a building worth 50M euros. That’s the asset side of the balance sheet. And at the liability side, the bank has 20M shareholders’ capital, 100M borrowing (bonds) and 100M deposits. Now the 100M loss from the reduction in the building’s value has been taken off, both from the building’s value (as an asset), and from the shareholders’ capital (at a part of the bank’s capital at the liability side). The situation is presented in the following table.


Capital20

Loans 50 Bonds Issued

100


Don’t get confused by the accounting. Simply see the above economic event as a loss for the owners. The owners made a loan of 150M euros, the borrower could not pay back, the bank confiscated his building, which however has a value of only 50 million euros, and therefore there was a loss of 100M euros. Therefore the owners’ wealth is reduced by 100M euros. Therefore only 20M (120M initial offering- 100M loss) of shareholder capital is left. You can look at it in this simple way if you are confused with the accounting. It makes no difference at all. The accounting simply records this loss in the bank’s books. But the loss has nothing to do with accounting. It is a real loss. A real loss generated from a real economic event, which cost to the bank’s shareholders 100M euros.

So, let’s now look at the bank’s capital. The bank has 20M of shareholder capital, 100M of borrowing (bonds), and 100M of deposits. Own capital (shareholder capital), now stands at 20M / 220M = 9%.

Share Capital 20MBonds Issued 100MDeposits 100MTotal Capital 220MShare Capital/ Total Capital = 20M/ 220M = 9 %

If the loss was greater the shareholder capital could have been totally erased. If the loss was even greater, a part of the bondholders’ and depositors’ capital could have been erased too. Imagine for example, that the loss was 200 million. All the 120 M of shareholder capital would have been erased. But another 80M euros would have been erased from bondholders and depositors. Actually it is right to assume that the 80M loss would be incurred by bond holders, since depositors are always the last ones to incur losses. If they incur any losses at all, since very often the government prefers to pass their part of the losses to the taxpayers.

How Recapitalization Takes Place

Now let’s go back to my example. There is a problem. Shareholders’ capital stands at 9% of total capital, and regulators require it to be at least 20%. Therefore the bank must be recapitalized. It is not a liquidity problem. The bank still has 170M euros in its vaults, and if depositors are not panicked and they do not rush to take their money there is no problem. The bank does not have a liquidity problem. But it has a capitalization problem. Shareholders’ capital stands at only 9% instead of 20%. Therefore the bank has to issue new shares, and receive new shareholders’ capital (be recapitalized) in order to meet minimum capital requirements. Under normal circumstances there is no problem. There are many people willing to buy the bank’s shares. But under a severe economic crisis, it is very likely that no one will be willing to risk his money by buying the troubled bank’s new shares.

If that happens, there are two options. Either the bank will close down and be liquidated, or the government will become a shareholder, by contributing the shareholder capital that is missing. In our example, the government would have to contribute 30M euros, thus bringing shareholder capital at 50 million euros, and therefore 50M / (50 + 100 + 100) = 20% of total capital, as required by regulation. Therefore the bank was recapitalized. It could have been recapitalized by the market instead. But in troubled countries it is very likely that the market will be afraid to buy such shares. In my example, after the bank was recapitalized, the government holds 60% of the bank’s share capital, and the market holds 40% of the bank’s capital.

Share Capital (20M Private and 30M Public)

50M

Bonds Issued 100MDeposits 100MTotal Capital 250MShare Capital/ Total Capital = 50M/ 250M = 20 %

If the losses had erased 100% of share capital, the government would hold 100% of share capital. I must now say that I made a simplification. I assumed that the bank’s share price in the stock market did not change during 2008. This is of course very unrealistic, but it is a simplification that greatly helped me to explain what recapitalization is. Bank recapitalization should not be confused with short term liquidity provided by central banks to the banking sector, when the latter faces the danger of liquidity crisis and bank runs. I now turn to liquidity crisis to make sure there is not confusion between the two.

A Banking Example with Liquidity Crisis

I hope that by now it is clear what bank recapitalization is and how it takes place. And why it is important of course. Liquidity crisis are something very different. To demonstrate what liquidity crisis are I will use an example again. There is a bank, with 100M euros share capital, and 200M euros in deposits. There is no debt this time. No operations have been undertaken yet. So there are 300M euros in the company’s vault, financed by 100M of share capital and 200M of deposits.

Like before, the bank issues a loan of 150M euros to a businessman wishing to buy a big building, and the building is used as collateral. As before, there is now 150M in cash at the bank’s vault, 150M in collateralised debt, which are financed as described above. But this time the businessman is very credit worthy, and has calculated everything correctly. Therefore he is not affected by the crisis. But due to the severe economic crisis, depositors are panicked and run to take their deposits from the banks. But the bank does not have 200M euros in its vault. It only has 150M euros in its vault. The bank does not have money to pay the depositors, even though it is perfectly healthy. In this case the central bank will provide liquidity to the bank, and when the confidence returns and depositors take their money back to the bank, the bank will return the short term liquidity to the central bank.

The real world

The government (central bank) support under liquidity crisis is very different from the government support under recapitalization. But in the economic crisis of the recent years, both kinds of support were required. Because huge amounts of housing values held as collateral by the banks were evaporated, and when the corresponding loans became red, heavy losses were incurred erasing shareholder value. Therefore there was a need for recapitalization. At the same time in many countries i.e. in Southern European countries, there was a loss in confidence, and depositors were taking their deposits either to put them under their matrices, or to send them to more secure northern banks.

I must mention that decreases in the value of houses held as collateral are only one of the possible sources of losses for the banks. There are many others. For instance in Greece, when the country’s debt was restructured in 2012 (a form of default actually), the Greek banks lost 37.5 billion euros. Because they were holding approximately 70 billion euros in government debt, and there was a haircut of approximately 50%.

If you think this was interesting, I have also written the following documents

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Economy & Finance

Bank Recapitalization