Applying Capital Structure basics in Banking

Simon Kwan of FRBSF has written a very nice primer on using capital structure lessons for banking. Capital Structure means what should a firm choose debt or equity for its capital?

Capital structure theories seek to explain why businesses choose different mixes of debt and equity to finance their operations. Banking firms represent a special case because of certain unique features in the industry, including a federal safety net and extensive regulation. The financial crisis of the past two years provided another set of special circumstances in which banks needed to raise capital. The preference banks have shown for issuing preferred shares in the private market in favor of government financing can be viewed through the lenses of capital structure theories.

Kwan first discusses capital structure theories which apply to general firms- tradeoff theory, pecking order theory, and free cash flow theory.

He then  says capital structure theories are different for banks

Banks and other depository institutions are specialized businesses whose capital structures are affected by a number of conditions unique to the banking industry, such as government regulation and access to a federal safety net that includes deposit insurance and borrowing through the Federal Reserve discount window. Deposit insurance was created to contain the rapid withdrawals from a bank whose financial condition may be in doubt.

He then discusses the capital structure of banks in this crisis and why banks issued preference shares in this crisis.

Useful stuff.

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One Response to “Applying Capital Structure basics in Banking”

  1. charles Says:

    this is a nice research work

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