Additional Equity Capital Research Articles

Impact of Higher Capital Requirements on Bank Funding Costs: Australian Evidence

This study examines the long-run cost implications for banks of funding more of their assets with equity capital, in an economy with a strong dependence on bank-intermediated financing and a highly concentrated banking industry. Despite domestic conditions that are likely to heighten expectations of government support for banks, we find robust evidence that equity investors are willing to accept a lower risk premium for investing in less leveraged banks. The relationship between the equity risk premium and leverage is not significantly affected by bank size. However, we find that equity pricing became more responsive to bank leverage after the 2007-2009 financial crisis. The impact of additional equity capital on the overall cost of bank funding is small (in the order of 0-3 basis points annually for each 1-percentage-point increase in the ratio of equity capital to risk-adjusted assets).

A Model of Capital Regulatory Arbitrage in Shadow Banking System

In response to the “capital regulatory arbitrage” view on shadow banking, this paper develops a simple model of capital regulatory arbitrage by risk averse banks in a shadow banking system. Banks inter-trade their assets to boost collateralized borrowing capacity from a large group of highly risk averse investors but capital requirement regulation deters them from fully exploiting this created borrowing capacity without incurring the cost of raising additional equity capital. However, to arbitrage this regulation banks need incur an arbitrage cost, which gives rise to the tradeoff for banks. We give a broad set of parameters with respect to which the relative magnitude of banks’ incentives to arbitrage can be discussed. Moreover, under a risk-averse setting for banks, the arbitrage cost can have quite uncertain effects on the stability of the shadow banking system with respect to different parameters. Lastly, we incorporate government bond and shadow bank debt together into a safe assets market, and take a criticism towards the view that higher funding cost always contributes to higher shadow banking stability even regardless of efficiency considerations.

Portfolio KVA: I Theory

XVA models for the calculation of CVA, FVA (see for example (Burgard and Kjaer 2013)), KVA(Green, Kenyon, and Dennis 2014), MVA (Green and Kenyon 2014) and TVA (Kenyon and Green 2014a) have frequently been formulated at the counterparty level. However, it is clear that some elements of the Regulatory Capital Framework are calculated at entity level rather than per counterparty (BCBS-128 2006; BCBS-189 2011) and hence the corresponding KVA term includes elements that are calculated across all counterparties. The Leverage Ratio for example, is clearly a function of all bank positions. Furthermore, in the KVA model of (Green, Kenyon, and Dennis 2014) capital was assumed to be readily available in any quantity at treasury level to be allocated down to individual businesses in return for the payment of a return\gamma_K. In practice, however, the central capital pool cannot be increased or decreased on demand. Additional equity capital is normally obtained through a rights issue, a relatively rare an expensive operation for a company, while equity capital can be returned to shareholders through stock buy backs, although these operations are highly regulated. The cost of capital at portfolio level should depend on the overall capital requirement in some way. Furthermore the act of trading and hedging can no longer be done at single counterparty level. A trade and hedge as a pair will imply two counterparties and capital changes due to both transactions. The hedge attracts capital and hence to hedge to overall portfolio will require an iterative process to neutralise the risk of the whole portfolio including KVA across all counterparty positions. Hence there are entity level aspects of XVA that have hitherto been ignored. This paper rectifies this problem by extending the Burgard-Kjaer semi-replication framework to multiple counterparties and multiple underlying assets, and allowing for entity-level capital requirements and effects. The work is presented in two parts, this paper covering theoretical and algorithmic developments and paper II covering practical examples and impact analysis.

A note on the appropriate choice of risk measures in the solvency assessment of insurance companies

Purpose – The concept of value at risk is used in the risk-based calculation of solvency capital requirements in the Basel II/III banking regulations and in the planned Solvency II insurance regulation framework planned in the European Union. While this measure controls the ruin probability of a financial institution, the expected policyholder deficit (EPD) and expected shortfall (ES) measures, which are relevant from the customer's perspective as they value the amount of the shortfall, are not controlled at the same time. Hence, if there are variations in or changes to the asset-liability situation, financial companies may still comply with the capital requirement, while the EPD or ES reach unsatisfactory levels. This is a significant drawback to the solvency frameworks. The paper aims to discuss these issues. Design/methodology/approach – The author has developed a model framework wherein the author evaluates the relevant risk measures using the distribution-free approach of the normal power approximation. This allows the author to derive analytical approximations of the risk measures solely through the use of the first three central moments of the underlying distributions. For the case of a reference insurance company, the author calculates the required capital using the ruin probability and EPD approaches. For this, the author performs sensitivity analyses considering different asset allocations and different liability characteristics. Findings – The author concludes that only a simultaneous monitoring of the ruin probability and EPD can lead to satisfactory results guaranteeing a constant level of customer protection. For the reference firm, the author evaluates the relative changes in the capital requirement when applying the EPD approach next to the ruin probability approach. Depending on the development of the assets and liabilities, and in the cases the author illustrates, the reference company would need to provide substantial amounts of additional equity capital. Originality/value – A comparative assessment of alternative risk measures is relevant given the debate among regulators, industry representatives and academics about how adequately they are used. The author borrows the approach in parts from the work of Barth. Barth compares the ruin probability and EPD approach when discussing the RBC formulas of the US National Association of Insurance Commissioners introduced in the 1990s. The author reconsiders several of these findings and discusses them in the light of the new regulatory frameworks. More precisely, the author first performs sensitivity analyses for the risk measures using different parameter configurations. Such analyses are relevant since in practice parameter values may differ from estimates used in the model and have a significant impact on the values of the risk measures. Second, the author goes beyond a simple discussion of the outcomes for each risk measure, by deriving the firm conclusion that both the frequency and magnitude of shortfalls need to be controlled.

Point of View: Overpayment of Manager Incentive Fees— When Preferred Returns and IRR Hurdles Differ

Executive Summary. An evolution has taken place interms of manager incentive fee documentation. Originally,incentive fees were based on a "preferred return"methodology whereas, today, most contracts use an IRRhurdle methodology. Although this change generally hasbeen treated as a non-event, the change has generatedunanticipated consequences that can be quite significant.In instances where additional equity capital is called afteran earlier split of profits, the equivalence of these twoformulations fails. Further, even when such is not thecase, if the investment is a portfolio and the contract allowsfor interim incentive fee payments based on onlyassets sold to date, the same problem can occur. For largeportfolios, millions of dollars of fees can hang in the balance,amounts that will accrue to the investor or themanager based solely on the calculation methodologyutilized. We believe that this phenomenon has been inadvertentlyembedded in many institutional real estateportfolio fee arrangements.With the recent sharp downturn in the real estate market,rates of return have been so low as to temporarilyrender this issue moot. With the market beginning to recover,this is an opportune time to 'daylight' this issue.

Corporate governance and investor reactions to seasoned equity offerings

PurposeThe purpose of this paper is to study the role of corporate governance in abnormal returns around announcements of seasoned equity offerings (SEOs) by publicly traded US firms from 2001 to 2004.Design/methodology/approachCross‐sectional regression analysis was used to determine which variables are important to the market's reaction to the SEO, with a particular focus on corporate governance variables.FindingsIt was found that investors react more positively for firms in which different people hold the CEO and board chairman positions. Limited evidence was found that investor reaction is more positive when the board has a greater representation of outside directors, the CEO has less ownership, and the board is not too large. These findings suggest that investors react more favorably to SEOs by firms with stronger corporate governance mechanisms that reduce adverse selection or agency problems.Practical implicationsThis paper's findings are evidence that stronger boards can reduce a firm's cost of raising additional equity capital. Originality/value – There is not believed to be any other published paper that examines the impact of corporate governance mechanisms on the reaction to SEOs with such a comprehensive sample or in post‐Enron periods.

Acquisition of Additional Equity Capital by Small Firms – Findings from the National Survey of Small Business Finances

While the importance of venture capital to the growth of small firms has been widely discussed during the past decade, little is known about the acquisition of additional equity capital, especially internal equity capital, by the majority of small firms in the U.S. This paper utilizes the information collected in the Federal Reserve Board’s 1993 and 1998 Small Business Finance Surveys to investigate the acquisition of additional equity capital by small firms. While the importance of public issue markets and venture capital investment in promoting the growth of small dynamic firms cannot be denied, the importance of external equity capital seems to be overstated. Only a very small number of small firms acquired additional external equity capital. It is the internal equity capital, not external, equity, that is one of the major financing sources for most small firms. We found that younger, lower quality firms were more likely to acquire additional internal equity capital than other firms. There appeared to be a “pecking order” of borrowing from internal sources to traditional lenders to non-traditional lenders. In addition, internal equity capital and debt acquired from traditional and non-traditional lenders appeared to be complementary financial resources.

The M&M Propositions 40 Years Later

Some months ago I was being deposed as an ‘expert economic witness’ in a law suit where our side was advancing, among other things, the view that a firm, not actually run by known thieves ready to abscond, could always raise additional equity capital. The firm might not want to raise more equity capital, but, in principle, it could. That’s basically just a straightforward, implication of the M&M perfect capital market assumption, I noted. As I was trying to explain that point in the course of my deposition, the attorney for the other side suddenly cut in and asked: ‘Professor. Do you or do you not believe the M&M Propositions are true?’ Fortunately, you cannot really be held to simple yes or no answers in a deposition. And I hope my inevitably longer answer to the opposing attorney can serve at least as a useful takeoff for my remarks today on the M&M Propositions and where they appear to stand. Let us first be clear what the M&M Propositions are that we are talking about. I will mean essentially the three capital structure propositions in the original 1958 article. Though I am sure no one here needs to be reminded, Proposition I, which is really the key to all the others, is the invariance proposition that the value of a firm, in the sense of the total value of its securities, depends only on the earning power and risk of its operating assets and not at all on the debt/equity composition of the liabilities. Otherwise, the capital markets would be out of equilibrium and arbitrage opportunities would exist. Proposition II goes on to show that if Proposition I holds, the expected return on levered shares will be a linear increasing function of leverage. And Proposition III— which is the one that figures most directly in the law suit—says, in effect, that the cost of capital, in the sense of the minimum expected rate of return required for a project to be just worth doing from the perspective of the current stockholders, is a property of the project and its risk, and not of the particular securities that happen to be used to finance it. I call these the capital structure propositions to distinguish them from the M&M dividend propositions though, as I pointed out in my 1988 survey article, even the dividend propositions are really subsumed under the capital structure

Seasoned equity offerings and the short‐ and long‐run performance of initial public offerings in the UK

AbstractIn contrast to the US practice, rights issues is the predominant method of raising additional equity capital in the London market. the UK evidence for the period 1980‐1991 provides no support to the hypothesis that IPO firms deliberately underprice to signal their quality and facilitate subsequent seasoned equity offerings. the level of initial returns is related neither to the size of the issue nor to the price response at the announcement of a rights issue. the results demonstrate, however, that firms with higher first day returns are quicker in returning to the market for additional equity capital. There is also strong evidence to suggest that the announcement of a seasoned equity offering follows a period of significant rises in the stock prices of reissuing firms. Such gains are, however, dissipated quickly in the 18 months after the announcement of the seasoned equity offering. the level of underperformance is particularly pronounced for firms that raised relatively small subsequent amounts of capital in relation to funds raised at the initial offering. Thus, the paper documents a pattern of post‐issue behaviour which is fundamentally similar for both unseasoned and seasoned equity offerings.

Alternative methods for raising capital

This paper provides an analysis of the choice of method for raising additional equity capital by listed firms. Examination of expenses reported to the SEC indicates that rights offerings involve significantly lower costs; yet underwriter are employed in over 90 percent of the offerings. The underwriting industry, finance textbooks, and corporate proxy statements offer several justifications for the use of underwriters. However, estimates of the magnitudes of these arguments indicate that they are insufficient to justify the additional costs of the use of underwriters. The use of underwriters thus appears to be inconsistent with rational, wealth-maximizing behavior by the owners of the firm. The paper concludes with an examination of alternate explanations of the observed choice of financing method.

Are Stock Rights Obsolete?

G ENERAL MOTORS, SOCONY MOBIL, National Gypsum, IBM, Babcock & Wilcox, Anaconda and Armco have recently issued stock rights to raise additional equity capital. Standard Oil of New Jersey and Royal Dutch Shell announced they will use this method in the near future. Adoption of any device by so many notable corporations might lead to the conclusion that this must be the best method. Surprisingly, there is at least some evidence that it is not. Advocates of and apologists for stock rights indicate (1) that in all fairness each stockholder must be given the privilege of maintaining his proportionate interest in the business, (2) that many company charters require equity offerings be made first to the stockholders, (3) that present stockholders constitute the most ready reservoir of new share capital available to the company and that large equity issues of $50 million and more are probably saleable only through the rights device, (4) that if rights were not offered to shareholders many of them would not be aware of the stock offering, (5) that most shareholders like rights and that it is a matter of good stockholder relations to give them what they want. This case on face may appear to some established, and perhaps it is, Yet, according to Plato, every coin front has its back; each good its bad. So investigation of both sides of the stock-rights problem should be made before reaching a conclusion. The author has made a limited telephone survey of underwriters, investment counsel, investment trusts, bank trust officers, stock exchange firm partners, insurance and pension fund executives. An overwhelming number of these persons expressed in no uncertain terms their opposition to stock rights. Perhaps a wider survey would have shown different results, but the fact that any survey of financial professionals could reveal almost a unanimity of disillusionment about stock rights seems significant.