Banking

Banking

Strategies for managing Bank capital and how bank capital affected the capital crunch in 2008

Bank capital is a very important component of a bank’s business. According to HOMÖLLE (2005), management of bank capital determines whether a bank succeeds or not. The amount of capital that a bank holds is influenced by a number of factors. First of these are the regulations on the same by the governing banking authorities. In a situation where the banking authorities require that a bank maintains a certain minimum capital threshold then each bank operating within the jurisdiction of the governing authorities must maintain the minimum otherwise its license will be revoked (GODLEWSKI, 2005). The Bank capital is also a function of the share capital invested in the bank by the owners. The other determinant is the trading history. Banks that report profits each year tend to retain reserves each year which increase the capital. The higher the capital the more secure a bank is against withdrawals of deposits. To effectively manage bank capital a bank can employ several strategies which include retaining part of the dividends. If a bank retains part of the dividends from its trading activities then it will boost the bank capital immensely and act as a security against unexpected withdrawals of time deposits (CHUDASRI, 2002). The other strategy includes offering share rights. This strategy will boost the share capital of a bank in that investors will increase the share capital beyond the stipulated reserves that are required by the banking governing authorities. Banks could also manage their capital reserves by floating their shares in the securities exchange. This is one way of increasing bank capital. The bank can also increase its capital by moving into less competitive but lucrative markets. This is a way of diversifying risks and increasing returns (HOMÖLLE, 2005).

Bank capital affected the capital crunch in 2008 in several ways. First of these is that most banks were highly leveraged and therefore could not access credit from lenders. This affected their capital because they could not access loans for investment to make more returns to increase their capital reserves. Most borrowers went bankrupt during the financial crisis which increased default rates on loans. Since most banks make most of their money from interest rates on loans most started making losses and this affected their capital reserves. The losses made eroded the capital reserves and this led to the credit crunch since banks could not lend below their statutory minimum reserves. Banks were very careful in the credit crunch in 2008 because they could not lend as much as they wanted because good borrowers were few and most of the loans secured by properties went bad (PASIOURAS, GAGANIS and ZOPOUNIDIS, 2006).

Strategies for managing interest rate risks

Interest rate income is perhaps the main revenue stream for banks. Managing interest rate risk is therefore the most important undertaking or responsibility for banks. Banks earn interest income from loans lend to borrowers. Banks also generate interest income from money used to purchase governmental securities such as government bonds, treasury bills etc. An adverse fluctuation in interest rates is therefore of great concern to bank managers (HOMÖLLE, 2005). Bank managers are very concerned when interest rates fluctuate wildly because this affects the income to be generated from money lend as loans. Banks can manage interest rate risk in a number of ways. The most foremost of these is diversification of investments (Independent Banker, 2012). Banks can diversify their investments by putting a large percentage of their investable funds in interest rate insensitive investments opportunities. This will ensure that once interest rates fluctuate a large portion of their income is assured/ secured. The next strategy is reducing the number of interest rate sensitive liabilities. Banks could manage this risk by minimizing those liabilities that are sensitive to interest rate fluctuations. For example banks could hedge loans using either futures or forwards contracts. This will reduce the rate sensitivity of such loans. The other strategy could be by diversifying their investments. Banks should not concentrate their investments in one sector (Risk, 2012). This is because if the sector is hit by unexpected adverse conditions that affect the returns then the bank’s income will be affected adversely. Banks should also employ people who are qualified to interpret the economic times and forecast the future economic conditions of a trading environment. This will enable a bank to make wise investment decisions and diversify its portfolio of investments wisely (SIAM and SM, 2010). The other strategy of managing interest rate risk is increasing rate sensitive assets and reducing rate sensitive liabilities. At any one given time banks should never have more rate sensitive liabilities than rate sensitive assets. This is because adverse an increase in interest rates will automatically wipe out the bank’s profits (DHANANI, FIFIELD, HELLIAR and STEVENSON, 2008).

A brief report on CAMELS ratings; its disadvantages and drawbacks

CAMELS ratings are used by banking authorities to assess banks using a number of parameters. The first parameter is capital adequacy. Banks are required to maintain a certain level of minimum capital threshold to ensure they are stable and can be trusted with public money. Banks that do not maintain the minimum threshold capital may even be deregistered or put into protective receivership. The second parameter is asset quality. Banks are required to maintain a certain level of soundness in the quality of their assets. The assets must possess a certain degree of soundness in returns assurance (HOMÖLLE, 2005). Those banks whose large percentage their assets returns are not assured to certain level or are bad are not rated highly than those with performing assets. Most regulatory authorities look at the loan books mostly. If the non-performing loans exceed a set minimum threshold then the banks is rated poorly. A bank may even be cautioned if most of its assets are adjudged as being bad. The third parameter under CAMELS rating is management quality. The type of management determines the stability and future financial soundness of a bank. Banks which are managed by highly qualified and seasoned professionals tend to outperform those that are managed by not so qualified managers (SIAM and SM, 2010). Banks with high caliber managers are rated highly. The next rating parameter is earnings quality. Regulators and investors are concerned with the trend performance of each bank. Those banks that report profits each year in comparison to peers are rated well. But those banks which report growing profits in comparison to peers are rated even better. The next parameter is liquidity. Liquidity is of paramount importance to banks because it determines whether a bank can take up emerging investment opportunities (LACEWELL, 2001). Banks that maintain high liquidity levels are rated highly than those than those that are not. The next parameter after liquidity is sensitivity to market risk. Banks that demonstrate that they are aware of what is going on in the environments that they operate in are able to design strategies that ensure a strategic fit is maintained at all times with the external environment. Such banks are rated highly. Banks can demonstrate this by presenting their strategic plans than capture what is going on their environments and demonstrate strategies to attain competitive advantage. The ratings range from composite 1 to composite 5. Composite 1 comprises banks that are outstanding in most of the parameters whereas composite 5 are banks that require intervention to improve their ratings (LACEWELL, 2001).

The main drawback of CAMELS ratings is biasness in assessing the banks. It may not make much sense to assess banks of different sizes based on the ratings because their asset portfolio sizes are different. A small bank may have performing assets that are small in nature but if compared to large banks its CAMELS rating may be poor. Assessing management quality is also a big issue as it depends on the perceptions of the assessor. It is debatable whether many years’ experience in the banking industry translates to quality management. Liquidity is also contentious because a bank may have high liquidity levels and be rated highly whereas one with low liquidity levels may be rated poorly but may be the one with high liquidity is unable to find investment opportunities to employ its excess liquidity into (LACEWELL, 2001). It may be subjective to determine the optimum liquidity levels to be judged against.

The main advantage of CAMELS rating is that it offers an opportunity to regulatory authorities to assess banks performance and safeguard the financial industry in a country. Without a rating standard, banks may take up public money and misuse it which in effect turns away investors (LACEWELL, 2001). A sound financial banking industry is an important ingredient in attracting foreign investors into a country. The standard offers a country with a tool to benchmark with other banks in other countries and helps to develop measures to improve the banking industry. The standard enables a country to safeguard its savings which is important in acquiring capital goods that are important in creating wealth for a country (LACEWELL, 2001).

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