This theory was developed further in the 1960s. This theory states that, there is no need for banks to lend self-liquidating loans and maintain liquid assets as they can borrow reserve money in the money market whenever necessary. A bank can hold reserves by building additional liabilities against itself via different sources.
These sources comprise of issuing time certificates of deposit, borrowing from other commercial banks, borrowing from the central banks, raising of capital funds through issuing shares, and by ploughing back of profits. We will look into these sources of bank funds in this chapter.
These deposits have different maturities ranging from 90 days to less than 12 months. They are transferable in the money market. Thus, a bank can have connection to liquidity by selling them in the money market. But this source has two demerits.
First, if during a crisis, the interest rate layout in the money market is higher than the ceiling rate set by the central bank, time deposit certificates cannot be sold in the market. Second, they are not reliable source of funds for the commercial banks. Bigger commercial banks have a benefit in selling these certificates as they have large certificates which they can afford to sell at even low interest rates. So the smaller banks face trouble in this respect.
A bank may build additional liabilities by borrowing from those banks that have excess reserves. But these borrows are only for a very short time, that is for a day or at the most for a week.
The interest rate of these types of borrowings relies on the controlling price in the money market. But borrowings from other banks are only possible when the economic conditions are normal economic. In abnormal times, no bank can afford to grant to others.
Banks also build liabilities on themselves by borrowing from the central bank of the country. They borrow to satisfy their liquidity requirements for short-term and by discounting bills from the central bank. But these types of borrowings are comparatively costlier than borrowings from other sources.
Commercial banks hold funds by distributing fresh shares or debentures. But the availability of funds through these sources relies on the volume of dividend or interest rate which the bank is prepared to pay. Basically banks are not prepared to pay rates more than paid by manufacturing and trading enterprises. Thus they fail to get enough funds from these sources.
The ploughing back of its profits is considered as an alternative source of liquid funds for a commercial bank. But how much it can obtain from this source relies on its rate of profit and its dividend policy. Larger banks can depend on these sources rather than the smaller banks.
Generally, bank capital comprises of own sources of asset finances. The volume of capital is equivalent to the net assets worth, marking the margin by which assets outweigh liabilities.
Capital is expected to secure a bank from all sorts of uninsured and unsecured risks suitable to transform into losses. Here, we obtain two principle functions of capital. The first function is to capture losses and the second is to establish and maintain confidence in a bank.
The different functions of capital funds are briefly described in this chapter.
Capital is required to permit a bank to cover any losses with its own funds. A bank can keep its liabilities completely enclosed by assets as long as its sum losses do not deplete its capital.
Any losses sustained minimize a bank’s capital, set off across its equity products like share capital, capital funds, profit-generated funds, retained earnings, relying on how its general assembly decides.
Banks take good care to fix their interest margins and other spreads between the income derived from and the price of borrowed funds to enclose their ordinary expenses. That is why operating losses are unlikely to subside capital on a long-term basis. We can also say that banks with a long and sound track record owing to their past efficiency, have managed to produce enough amount of own funds to easily cope with any operating losses.
For a new bank without much of a success history, operating losses may conclude driving capital below the minimum level fixed by law. Banks run a probable and greater risk of losses coming from borrower defaults, rendering some of their assets partly or completely irrecoverable.
A bank may have sufficient assets to back its liabilities, and also adequate capital power which balances deposits and other liabilities by assets. This generates a financial flow in the ordinary course of banking business. Here, it is an important necessity that a bank’s capital covers its fixed investments like fixed assets, involving interests in subsidiaries. These are used in its business operation, which basically generate no financial flow.
If the cash flow generated by assets falls short of meeting deposit calls or other due liabilities, it is not difficult for a bank with sufficient capital backing and credibility to get its missing liquidity on the interbank market. Other banks will not feel uncomfortable lending to it, as they are aware of the capacity to conclude its liabilities with its assets.
This type of bank can withstand a major deposit flight and refinance it with interbank market borrowings. In banks with a sufficient capital base, anyhow, there is no reason to fear a mass-scale depositor exodus. The logic is that the issues which may trigger a bank capture in the first place do not come in the limelight. An alternating pattern of liquidity with lows and highs is expected, with the latter occurring at times of asset financial inflow outstripping outflow, where the bank is likely to lend its excess liquidity.
Banks are restricted not to count on the interbank market to clarify all their issues. In their own interest and as expected by bank regulators, they expect to match their assets and liability maturities, something that permits them to sail through stressful market situations.
Market rates could be affected due to the intervention of Central Bank. There can be many factors contributing to it like the change in monetary policy or other factors. This could lead to an increase in market rates or the market may collapse. Depending upon the market problem the banks may have to cut down the client lines.
As deposits are unfit for the purpose, it is up to capital to provide funds to finance fixed investments (fixed assets and interests in subsidiaries). This particular function is apparent when a bank starts up, when money raised from subscribing shareholders is used to buy buildings, land and equipment. It is desirable to have permanent capital coverage for fixed assets. That means any additional investments in fixed assets should coincide with a capital rise.
During a bank’s life, it generates new capital from its profits. Profits not distributed to shareholders are allocated to other components of shareholders’ equity, resulting in a permanent increase. Capital growth is a source of additional funds used to finance new assets. It can buy new fixed assets, loans or other transactions. It is good for a bank to place some of its capital in productive assets, as any income earned on self-financed assets is free from the cost of borrowed funds. If a bank happens to need more new capital than it can produce itself, it can either issue new shares or take a subordinated debt, both an outside source of capital.
Capital is a widely used reference for limits on various types of assets and banking transactions. The objective is to prevent banks from taking too many chances. The capital adequacy ratio, as the main limit, measures capital against risk-weighted assets.
Depending on their respective relative risks, the value of assets is multiplied by weights ranging from 0 to 20, 50 and 100%. We use the net book value here, reflecting any adjustments, reserves and provisions. As a result, the total of assets is adjusted for any devaluation caused by loan defaults, fixed asset depreciation and market price declines, as the amount of capital has already fallen due to expenses incurred in providing for identified risks. That exposes capital to potential risks, which can lead to future losses if a bank fails to recover its assets.
The minimum required ratio of capital to risk-weighted assets is 8 percent. Under the applicable capital adequacy decree, capital is adjusted for uncovered losses and excess reserves, less specific deductible items. To a limited extent, subordinated debt is also included in capital. The decree also reflects the risks contained in off-balance sheet liabilities.
In the restrictive function context, it is the key importance of capital and the precise determination of its amount in capital adequacy calculations that make it a good base for limitations on credit exposure and unsecured foreign exchange positions in banks. The most important credit exposure limits restrict a bank’s net credit exposure (adjusted for recognizable types of security) against a single customer or a group of related customers at 25% of the reporting bank’s capital, or at 125% if against a bank based in Slovakia or an OECD country. This should ensure an appropriate loan portfolio diversification.
The decree on unsecured foreign exchange positions seeks to limit the risks caused by exchange rate fluctuations in transactions involving foreign currencies, capping unsecured foreign exchange positions (the absolute difference between foreign exchange assets and liabilities) in EUR at 15% of a bank’s capital, or 10% if in any other currency. The total unsecured foreign exchange position (the sum of unsecured foreign exchange positions in individual currencies) must not exceed 25% of a bank’s capital.
The decree dealing with liquidity rules incorporates the already discussed principle that assets, which are usually not paid in banking activities, need to be covered by capital. It requires that the ratio of the sum of fixed investments (fixed assets, interests in subsidiaries and other equity securities held over a long period) and illiquid assets (less readily marketable equity securities and nonperforming assets) to a bank’s own funds and reserves not exceed 1.
Owing to its importance, capital has become a central point in the world of banking. In leading world banks, its share in total assets/liabilities moves between 2.5 and 8 %. This seemingly low level is generally considered sufficient for a sound banking operation. Able to operate at the lower end of the range are large banks with a quality and well-diversified asset portfolio.
Capital adequacy deserves constant attention. Asset growth needs to respect the amount of capital. Eventually, any problems a bank may be facing will show on its capital. In commercial banking, capital is the king.