International Banking Essay

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Discuss the Reasons why Banks are being encouraged to Hold More Equity Capital and Consider the Implications of this for Regulatory Policy

Jiale Song Student ID:5160734 Tutor: Paul Gower Date:21/03/2014

Financial regulation requires banks to hold a certain amount of capital. When the financial crisis started in 2007, the capital of banks had fallen significantly. From 2008, when many banking institutions collapsed regulators had to increase capital requirements. There have been many proposals that capital requirements should be increased even further (PWC, 2013). In simplest terms, equity capital is money that is given to a business entity in exchange for partial ownership. This ownership takes the form of stocks or stocks that gain in value and interest over time. The money invested in equity capital is never repaid in the traditional manner (Kirstein, 2010). The value of equity capital is computed by estimation of the current market value of everything a company owns from which the total liabilities is subtracted. Bank capital requirements are regulations that require a bank to maintain some minimum ration of capital such as equity to stocks. The main purpose is to ensure that banks are able to ensure that banks are able to sustain huge unexpected losses in the values of the assets that they hold and at the same time they honour withdrawals and other obligations (Ben, 2013).
The Basel Committee on banking supervision, started in 1974 by central banks of the G-10 nations, has endeavoured to standardize capital requirements in the world. Before the financial crisis of 2008, the minimum capital requirements were 8%, but the crisis persuaded regulators and other policy making institutions that these requirements should be raised. The costs of high equity capital requirements come with reduced banking activities mainly reduced lending that may result from sudden losses. These capital requirements require that a fraction of the banks’ assets be funded by with un-borrowed money. By having a minimum ratio of un-borrowed assets is a method that limits the share of assets funded from outside borrowed sources. This is because borrowed capital is obtained without making any promise of payments at a specific point in time. A bank with more equity capital increases the bank’s ability to absorb losses on its assets (Admati, & Hellwig, 2013). Banks can increase this equity capital through the stock markets and those that cannot access the capital markets can reinvest profits. Banks that are viable can increase their un-borrowed capital and still maintain the same rate of lending (Charles, 2012).
The recent financial risk proved that systematic risk in the banking and the larger financial sector is very important. Financial distress in one financial institution can easily spread into other financial institution and easily cause a credit crunch or an asset implosion on prices. This has made it a top priority for the financial regulatory institutions to reduce the risk of financial distress among the large financial institution so that they will not transmit these systematic risks to other financial institutions. The only way that the financial institutions could lower risks would be to increase the funding in terms of un-borrowed funds. Prior to the financial crisis banks were highly leveraged hence the reason for the implosion of the crisis (Kupiec, 2005).
Another benefit for more equity capital is that it increases the stability of banks. Although some argue that balance sheets have to be reduced in response to additional equity requirements or reduced deposits. Through issuing new capital banks are able to increase capital requirements without any repercussion on their other profitable or social activities such as lending (Andrea, 2007).
Banks can increase equity capital through increased…