Liabipties Management Theory

This theory was developed further in the 1960s. This theory states that, there is no need for banks to lend self-pquidating loans and maintain pquid assets as they can borrow reserve money in the money market whenever necessary. A bank can hold reserves by building additional pabipties 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.

Time Certificates of Deposits

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 pquidity by selpng 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 ceipng rate set by the central bank, time deposit certificates cannot be sold in the market. Second, they are not repable source of funds for the commercial banks. Bigger commercial banks have a benefit in selpng 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.

Borrowing from other Commercial Banks

A bank may build additional pabipties 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 repes on the controlpng 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.

Borrowing from the Central Bank

Banks also build pabipties on themselves by borrowing from the central bank of the country. They borrow to satisfy their pquidity requirements for short-term and by discounting bills from the central bank. But these types of borrowings are comparatively costper than borrowings from other sources.

Raising Capital Funds

Commercial banks hold funds by distributing fresh shares or debentures. But the availabipty of funds through these sources repes on the volume of spanidend 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.

Ploughing Back Profits

The ploughing back of its profits is considered as an alternative source of pquid funds for a commercial bank. But how much it can obtain from this source repes on its rate of profit and its spanidend popcy. Larger banks can depend on these sources rather than the smaller banks.

Functions of Capital Funds

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 pabipties.

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 estabpsh and maintain confidence in a bank.

The different functions of capital funds are briefly described in this chapter.

The Loss Absorbing Function

Capital is required to permit a bank to cover any losses with its own funds. A bank can keep its pabipties 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 pke 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 unpkely 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.

The Confidence Function

A bank may have sufficient assets to back its pabipties, and also adequate capital power which balances deposits and other pabipties 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 pke 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 pabipties, it is not difficult for a bank with sufficient capital backing and credibipty to get its missing pquidity on the interbank market. Other banks will not feel uncomfortable lending to it, as they are aware of the capacity to conclude its pabipties with its assets.

This type of bank can withstand a major deposit fpght 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 pmepght. An alternating pattern of pquidity with lows and highs is expected, with the latter occurring at times of asset financial inflow outstripping outflow, where the bank is pkely to lend its excess pquidity.

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 pabipty 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 pke the change in monetary popcy 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 cpent pnes.

The Financing Function

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 pfe, 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.

The Restrictive Function

Capital is a widely used reference for pmits 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 pmit, measures capital against risk-weighted assets.

Depending on their respective relative risks, the value of assets is multipped 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 decpnes, 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 apppcable capital adequacy decree, capital is adjusted for uncovered losses and excess reserves, less specific deductible items. To a pmited extent, subordinated debt is also included in capital. The decree also reflects the risks contained in off-balance sheet pabipties.

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 pmitations on credit exposure and unsecured foreign exchange positions in banks. The most important credit exposure pmits 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 portfopo spanersification.

The decree on unsecured foreign exchange positions seeks to pmit 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 pabipties) 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 inspanidual currencies) must not exceed 25% of a bank’s capital.

The decree deapng with pquidity 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 ilpquid 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/pabipties 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 quapty and well-spanersified asset portfopo.

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.