Risk Management and Value Creation in ... - Arabictrader.com

Capital Structure in Banks 147
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Equity (book) capital: This is the most junior claim there is and cannot
be withdrawn in times of crisis (making it “patient money”). However,
equity capital may not always limit risk taking. Whereas equity
limits risk taking in the form of (financial) leverage, it does not always
limit portfolio risk taking—at least as long as it is not closely
enough tied to portfolio risk, which is the case for book equity.
Therefore, higher equity ratios do not always predict a lower probability
of default and often explain little of the variation in bank
performance. 54
Subordinated debt: This is the second most junior claim after equity.
It can be considered “patient money,” since it usually has a longterm
maturity and is difficult to redeem even in a crisis. Whereas it
may increase the (financial) leverage risk of a bank, it can reduce
portfolio risk taking: if subordinated creditors are not protected by
deposit insurance (which they are usually not 55 ), they have an incentive
to closely monitor the bank’s risk taking and restrict it if necessary.
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Uninsured debt (senior debt and other uninsured deposits): It immediately
appears that these claims are not junior (enough). Since they
are additionally not considered to be “patient money,” because
they are likely to be the first to be withdrawn during a “run,” 57 uninsured
debt is not considered to be regulatory capital—even though it
creates the incentive to more closely monitor the bank’s risk taking.
Therefore, from a regulatory point of view, so-called Tier-1 and Tier-2
capital is accepted 58 as such a buffer. Both are actual (book) capital amounts
54 As Berger et al. (1995b), p. 409, state after an extensive discussion of the literature:
“The theoretical issue of how higher required equity ratios affect bank risk-taking
is unresolved.” Also, empirical evidence proves that higher equity ratios are associated
with a lower default probability—although the relationship is often relatively
weak.
55 Differing views often assume that “too-big-to-fail” intervention applies even to
subordinated debt and will, therefore, reduce the willingness to monitor.
56 This view of the subordinated debt holders is similar to the view of many stakeholder
groups: being exposed to downside risk that exceeds shareholder equity.
57 For instance, according to Gup (1998), p. 53, Continental Illinois (which defaulted
in 1984) relied heavily on uninsured (senior) deposits provided by institutional investors
(because they were not allowed to run branch banks under the then-valid
regulation). After the first rumors of trouble at Continental Illinois, these uninsured
deposits were the first hit by the “run” leading to withdrawals of US$ 8 billion per
day.
58 For instance, the EU Capital Adequacy Directive based on the recommendations
of the Basle Committee defines these capital amounts in detail.