Posts Tagged ‘Structure’
Capital Structure and Risk in Islamic Financial Services
Capital Structure and Risk in Islamic Financial Services
Introduction: Information, Risks, and Capital
Financial intermediation is a critical factor for growth and social inclusion. One of its core functions is to mobilize financial resources from surplus agents and channel them to those with deficits. It thus allows investor entrepreneurs to expand economic activity and employment opportunities. It also enables household consumers, micro- and small entrepreneurs to expand their own welfare and earnings opportunities, and seek to smooth their lifetime outlays. In all cases, financial intermediation drives economic growth and contributes to social inclusion, provided it is conducted in a sound and efficient way.[1]
A financial intermediary’s ability to process information on risks and returns of investment opportunities will have a bearing on the soundness and efficiency of its resource mobilization and reallocation function. Conventional financial services (CFSs) process information through institutions or markets, and have generally evolved from the former to the latter. In both cases, markets and agents provide alternative ways of processing information on risks and returns of investment opportunities. In the first form, the intermediary raises capital to set up business to collect generally liquid deposits from surplus agents and reallocates these resources, now in his trust, to ones with deficits in generally less liquid assets. In the second form, surplus agents buy directly financial assets that represent a debt of a deficit agent or an ownership share in its business. In either approach, both categories of agents engage in transactions on the basis of trust and of expectations about the degree of liquidity that would provide the option to re-contract at a reasonable cost.[2] In the case of banks, the trust can be seen as based on proprietary information. In the case of markets, the information is more commoditized and widely available.[3]
Efficiently processed information can support the efficient allocation of capital. It can help a financial intermediary to better define the capital it would need to achieve the returns sought, while maintaining its ability to face the financial consequences of unexpected events that may endanger its stability. Banks engage in gathering and processing information on clients and markets, which allows them to manage different risks by unbundling them and reallocating the components. By performing these services soundly and efficiently, banks can manage to calibrate their capital requirements and receive diversified income streams. Thus a bank’s investors and customers can gain comfort as to its reliability in allowing them to access liquidity and maintain stability. In parallel with banks, financial markets can also convey the same sense of access to liquidity and stability based on disclosed and broadly available information on market participants. Markets can provide deficit and surplus agents a direct role in processing information to facilitate the unbundling and reallocation of risks and the efficient use of capital. Thus, banks and markets compete and complement each other in financial intermediation. The competition puts pressure on individual agents to use capital at their disposal efficiently, and results in a system-wide improved allocation of capital resources.[4]
Institutions offering Islamic financial services (IIFSs) also process information on risks and returns of investment opportunities while complying with Shari’ah principles.[5] Thus, in principle, they can be expected to increase competition in financial information processing by inducing better risk management and capital use. Such competition can be expected over time to lead to an efficient use of capital at the level of each financial agent, whether they practice conventional or Islamic finance, and in aggregate, system-wide across all modes of financial intermediation. Efficient use of capital is thus a challenge which competition imposes on all financial intermediaries, whether offering Islamic financial services or conventional financial services. At the same time, Islamic financial intermediation needs to comply with Shari’ah principles, notably those of risk sharing and materiality of financial transactions. Shari’ah compliance, social responsibility, and the discipline of competition compound IIFSs’ challenge to process information efficiently in order to manage the risks they may face and use their capital endowments. Thus, by their very nature and the environment in which they generally operate, IIFSs need to be well equipped with the information and skills that can allow them to identify their capital resources and use them efficiently.
This chapter argues for the need for Islamic financial services to strengthen risk management practices in the process of defining their own capital requirements in accordance with their loss tolerance. It suggests that IIFSs could invest in the collection of loss information and adoption of loss data management systems. IIFSs would benefit from implementing risk management methodologies and adapting their staffing skills accordingly. The chapter starts in Section 2 by outlining views on the relationship between risk management and capital for financial intermediation. It then overviews risk categories as an initial step in risk management in Section 3. Section 4 discusses regulatory and economic capital, introducing risk occurrence frequency as a distribution probability. Section 5 concludes with suggestions on steps that may help with risk management and improve the competitiveness of IIFSs.
2. Bank Capital and Risk Management
Bank capital may be considered as consisting of (a) equity capital and (b) certain non-deposit liabilities or debt capital (see Section 4). It is both a means of funding earnings-generating assets and a stability cushion. From the perspective of efficiency and returns, capital is part of a bank’s funding that can be applied directly to the purchase of earning assets, as well as being used as a basis for leverage to raise other funds for expanding assets with the net benefit accruing to shareholders. From a perspective of stability, bank capital is a cushion for absorbing shocks of business losses and maintaining solvency, with benefits accruing to depositors and other stakeholders. Both financial intermediaries and regulators are sensitive to the dual role of capital, as a means of funding earnings-generating assets and as a cushion for dealing with unanticipated events. Financial intermediaries may tend to be more focused on the former role and regulators on the latter.
A bank’s capital structure decision relates to the ratio of capital to deposits and to the ratio of debt capital to equity capital. Its performance, in terms of return on equity capital, will be influenced by its ability to calibrate the level of capital it requires. Through efficient risk management, it can reach a sense of which capital structure can best help it to: (a) achieve profitability while maintaining stability; (b) reassure markets as to the quality of its business conduct; and (c) have a constructive dialogue with regulators.
Efficient use of capital will help IIFSs to achieve profitability and stability. Allocating capital resources to low-performing or excessively risky assets is bound to drag down performance, endanger stability, or both. Equally, leaving capital idle entails at best forgoing earnings opportunities. For instance, overly cautious approaches that lead financial intermediaries to maintain larger amounts of capital than warranted by their risk profile may not allow them either to obtain the full potential of their capital or to contribute effectively to the development of the communities they serve. At the other end of the spectrum, a financial intermediary overly eager to achieve returns may allocate resources to highly risky assets that offer high returns but endanger stability. Explicit risk management practices can help in the selection of assets to which capital and other resources are applied and calibrate the level of capital that best suits business objectives and stability tolerance.
The size and composition of the resources that capital enables financial intermediaries to raise are likely to affect their profitability and stability. In a frictionless world where full information is available and markets are complete, the value of a firm would be independent of its capital structure, and so the focus should be on capital level and not structure.[6] Under such circumstances, the method by which a financial intermediary raises its required funds would be irrelevant. However, financial intermediaries do not operate in a frictionless world; they face imperfections such as costs of bankruptcy and financial distress, transaction costs, asymmetric information, or taxes. They also operate within the framework of a governing regulation possibly with a deposit insurance scheme that is expected to provide a safety net. In fact, one may contend that these market imperfections are the very reason for the successful existence of banks as financial intermediaries. Accordingly, not only a financial intermediary’s level of capital but also its structure is likely to bear on its market valuation, its business conduct, and its stability. Effective risk management strategies should contribute to a financial intermediary’s ability to assess not only the level of capital it would need in relation to assets and deposits, but also the extent to which its structure affects its value.
Market discipline contributes to responsible corporate behavior. Markets’ reactions to perceptions of a financial intermediary’s business conduct and capital strength may be unforgiving. It is thus in the interest of financial intermediaries to develop approaches to defining capital resource requirements that take into account the institutional environment in which they operate. The market’s perception of market imperfections is likely to influence views on the appropriate level of capital and the capital adequacy of financial intermediaries. For example, the availability of a safety net may lead market participants to be less demanding as to the need for capital in relation to bank assets. Conversely, anticipation of high costs of financial distress to depositors and other stakeholders may induce market participants to require the holding of more capital proportionally to assets. Similarly, wherever the institutional environment is weak and contract enforcement is uncertain and costly, markets may expect financial intermediaries to adapt the capital they hold.
The management of capital structure should in principle mitigate the risk of bank failures. When comparing a highly leveraged bank and a bank that is well capitalized, the leveraged bank will likely experience a greater loss of value during times of financial distress when the asset quality deteriorates, due to the increased risk of bankruptcy. To cope with downturns, in most countries banks hold a minimum amount of capital, based on the risk embedded in their asset holding. Accordingly, banks with relatively risky assets would hold a higher amount of capital than those banks with less risky assets. However, fearing the harshness of market discipline, many banks maintain a higher level of capital than the minimum required to allay the perception that they may be undercapitalized and avoid the losses this may induce, as witnessed in the 1980s. The key capital adequacy ratio provides an assessment of just how adequately the capital cushions such fluctuations in the bank’s earnings and supports higher assets growth.
Finally, efficient risk management should allow financial intermediaries to have a constructive dialogue with regulators. It would help them to articulate their views with respect to capital needs. The regulators’ rationale for regulating capital stems from the perception of the public-good nature of bank services, their potential macroeconomic growth and stability impact, and experience with costly bank failures. According to some estimates, such costs have varied between 3% and 55% of GDP.[7] Thus, regulators’ concerns with possible systemic risk resulting from the contagion effects of bank runs lead them to seek to mitigate risks of financial distress with regulatory requirements on banks’ capital.[8] Regulators’ concerns may be compounded by the presence of deposit insurance schemes. The moral hazard that may result from deposit insurance may lead to additional regulatory requirements such as linking the level of insurance premia to the risk embedded in assets and captured in associated risk weights. Indeed, deposit insurance may induce banks to lever up capital by expanding their own funding with liabilities, thus placing more risk on their capital and increasing their vulnerability. Efficient risk management practices would allow banks to improve their dialogue with the regulator and convey more convincingly their views on their soundness and capital requirements.
Regulators would generally also be concerned with the overall impact on the economy of the resources raised by the financial system under their purview. From an economy-wide perspective, banks may be viewed as firms’ competitors in raising capital on financial markets. The outcome of this competition has a bearing on economic performance and financial stability, and points to a cost–benefit tradeoff in holding capital. For instance, Gersbach (2007) suggests that a benefit of bank capital is the equity acting as a buffer against future losses, thereby reducing excessive risk taking of the banks. At the same time, raising bank capital may lead to a crowding out of industrial firms, limiting their access to equity and other market funding and also impacting their access to funding from banks and its cost. Furthermore, raising equity on markets may increase the cost of banks’ resources, inducing them to seek to invest in higher-yielding but more risky assets and thereby increasing their risk exposure. Thus, while potentially providing a cushion against unforeseen events, a higher level of equity may actually induce more risk taking, notably through raising the cost of funds to banks and their clients. Efficient risk management can provide inputs to both banks and regulators to better calibrate capital needs and deal with the foregoing type of tradeoff.
The level of a financial intermediary’s capital may also have a bearing on its ability to provide liquidity. The financial intermediary provides liquidity by funding assets that may be less liquid than the deposit resources it collects. There is a view that requirements for higher levels of capital may have a negative impact on liquidity creation.[9] On the liability side, a higher capital requirement may lead to a corresponding reduction in the level of deposits, thus constraining the ability to provide liquidity. Also, higher capital requirements may induce financial intermediaries to be more restrained in extending financing, thus constraining their ability to provide liquidity. However, according to another view, higher capital would allow the financial intermediary to create more liquidity since its risk-absorptive capacity would be improved.[10] In this regard, an empirical study concluded that for larger banks capital has a statistically significant positive net effect on liquidity creation, while for small banks this effect is negative.[11] Accordingly, each financial intermediary would need to evaluate carefully the level and composition of the capital it needs, since the latter plays a significant role in its ability to function as a liquidity provider. Equally, regulators would need to pay attention to the impact which capital requirement would have on the funding of the economy.
IIFS’s risk management arrangements will bear on their ability to calibrate capital to their business objectives and risk tolerance, to deal with market discipline, and to maintain a dialogue with regulators. The IIFS’s characteristic of mobilizing funds in the form of risk-sharing investment accounts in place of conventional deposits, together with the materiality[12] of financing transactions, may alter the overall risk of the balance sheet and, consequently, the assessment of their capital requirements. Indeed, risk-sharing “deposits” would in principle reduce the need for a safety cushion to weather adverse investment outcomes. Similarly, the materiality of investments is likely to modify the extent of their risk and have a bearing on the assessment for the overall need for capital; asset-based modes of finance may be less risky and profit-sharing modes more risky, than conventional interest-bearing modes. Nevertheless, IIFSs would operate within a regulatory framework that is likely to impose on them capital requirements with a view to promoting stability and limiting contagion risks. However, besides regulatory and market demands for IIFSs to hold capital, IIFSs need to put in place risk management assessments for their own purposes of returns and stability in accordance with the requirements of Shari’ah, their own mission statements, and the protection of their stakeholders.
[1] See Honohan (2004) and Levine (2004).
[2] Sir John Hicks identifies such liquidity as one of the main factors behind the Industrial Revolution.
[3] Actually, a deposit can be viewed as a purchase of a debt asset issued by the intermediary and redeemable at its face value.
[4] The institution–market competition is reflected in the trends of their relative market shares of total financial assets. For example, in the United States, between 1960 and the early 1990s, commercial banks’ share of total financial intermediaries’ assets fell from around 40% to less than 30%. See Edwards (1996).
[5] They do respond to a latent demand for financial services that do not breach Shari’ah principles. Accordingly, they have the potential to contribute to financial deepening, economic growth, and social inclusion. See also Burghardt and Fuss (2004).
[6] Modigliani and Miller (1958).
[7] See Klingebiel and Laeven (2007).
[8] Views differ on the need for and extent of regulation, as well as on the usefulness of deposit insurance; see Barth, Caprio, and Levine (2007).
[9] Diamond and Rajan (2006).
[10] Allen and Gale (2007).
[11] Berger and Bouwman (2005).
[12] By the “materiality” of financing transactions is meant that, in such transactions, capital must be “materialized” in the form of an asset or asset services (as in Murabaha credit sales, Salam and Istisna’a financing, or Ijarah leasing), or of a business venture (Musharakah or Mudarabah). Capital in the form of money is not entitled to any return, as this would be interest (riba).
Introduction: Information, Risks, and Capital
Financial intermediation is a critical factor for growth and social inclusion. One of its core functions is to mobilize financial resources from surplus agents and channel them to those with deficits. It thus allows investor entrepreneurs to expand economic activity and employment opportunities. It also enables household consumers, micro- and small entrepreneurs to expand their own welfare and earnings opportunities, and seek to smooth their lifetime outlays. In all cases, financial intermediation drives economic growth and contributes to social inclusion, provided it is conducted in a sound and efficient way.[1]
A financial intermediary’s ability to process information on risks and returns of investment opportunities will have a bearing on the soundness and efficiency of its resource mobilization and reallocation function. Conventional financial services (CFSs) process information through institutions or markets, and have generally evolved from the former to the latter. In both cases, markets and agents provide alternative ways of processing information on risks and returns of investment opportunities. In the first form, the intermediary raises capital to set up business to collect generally liquid deposits from surplus agents and reallocates these resources, now in his trust, to ones with deficits in generally less liquid assets. In the second form, surplus agents buy directly financial assets that represent a debt of a deficit agent or an ownership share in its business. In either approach, both categories of agents engage in transactions on the basis of trust and of expectations about the degree of liquidity that would provide the option to re-contract at a reasonable cost.[2] In the case of banks, the trust can be seen as based on proprietary information. In the case of markets, the information is more commoditized and widely available.[3]
Efficiently processed information can support the efficient allocation of capital. It can help a financial intermediary to better define the capital it would need to achieve the returns sought, while maintaining its ability to face the financial consequences of unexpected events that may endanger its stability. Banks engage in gathering and processing information on clients and markets, which allows them to manage different risks by unbundling them and reallocating the components. By performing these services soundly and efficiently, banks can manage to calibrate their capital requirements and receive diversified income streams. Thus a bank’s investors and customers can gain comfort as to its reliability in allowing them to access liquidity and maintain stability. In parallel with banks, financial markets can also convey the same sense of access to liquidity and stability based on disclosed and broadly available information on market participants. Markets can provide deficit and surplus agents a direct role in processing information to facilitate the unbundling and reallocation of risks and the efficient use of capital. Thus, banks and markets compete and complement each other in financial intermediation. The competition puts pressure on individual agents to use capital at their disposal efficiently, and results in a system-wide improved allocation of capital resources.[4]
Institutions offering Islamic financial services (IIFSs) also process information on risks and returns of investment opportunities while complying with Shari’ah principles.[5] Thus, in principle, they can be expected to increase competition in financial information processing by inducing better risk management and capital use. Such competition can be expected over time to lead to an efficient use of capital at the level of each financial agent, whether they practice conventional or Islamic finance, and in aggregate, system-wide across all modes of financial intermediation. Efficient use of capital is thus a challenge which competition imposes on all financial intermediaries, whether offering Islamic financial services or conventional financial services. At the same time, Islamic financial intermediation needs to comply with Shari’ah principles, notably those of risk sharing and materiality of financial transactions. Shari’ah compliance, social responsibility, and the discipline of competition compound IIFSs’ challenge to process information efficiently in order to manage the risks they may face and use their capital endowments. Thus, by their very nature and the environment in which they generally operate, IIFSs need to be well equipped with the information and skills that can allow them to identify their capital resources and use them efficiently.
This chapter argues for the need for Islamic financial services to strengthen risk management practices in the process of defining their own capital requirements in accordance with their loss tolerance. It suggests that IIFSs could invest in the collection of loss information and adoption of loss data management systems. IIFSs would benefit from implementing risk management methodologies and adapting their staffing skills accordingly. The chapter starts in Section 2 by outlining views on the relationship between risk management and capital for financial intermediation. It then overviews risk categories as an initial step in risk management in Section 3. Section 4 discusses regulatory and economic capital, introducing risk occurrence frequency as a distribution probability. Section 5 concludes with suggestions on steps that may help with risk management and improve the competitiveness of IIFSs.
2. Bank Capital and Risk Management
Bank capital may be considered as consisting of (a) equity capital and (b) certain non-deposit liabilities or debt capital (see Section 4). It is both a means of funding earnings-generating assets and a stability cushion. From the perspective of efficiency and returns, capital is part of a bank’s funding that can be applied directly to the purchase of earning assets, as well as being used as a basis for leverage to raise other funds for expanding assets with the net benefit accruing to shareholders. From a perspective of stability, bank capital is a cushion for absorbing shocks of business losses and maintaining solvency, with benefits accruing to depositors and other stakeholders. Both financial intermediaries and regulators are sensitive to the dual role of capital, as a means of funding earnings-generating assets and as a cushion for dealing with unanticipated events. Financial intermediaries may tend to be more focused on the former role and regulators on the latter.
A bank’s capital structure decision relates to the ratio of capital to deposits and to the ratio of debt capital to equity capital. Its performance, in terms of return on equity capital, will be influenced by its ability to calibrate the level of capital it requires. Through efficient risk management, it can reach a sense of which capital structure can best help it to: (a) achieve profitability while maintaining stability; (b) reassure markets as to the quality of its business conduct; and (c) have a constructive dialogue with regulators.
Efficient use of capital will help IIFSs to achieve profitability and stability. Allocating capital resources to low-performing or excessively risky assets is bound to drag down performance, endanger stability, or both. Equally, leaving capital idle entails at best forgoing earnings opportunities. For instance, overly cautious approaches that lead financial intermediaries to maintain larger amounts of capital than warranted by their risk profile may not allow them either to obtain the full potential of their capital or to contribute effectively to the development of the communities they serve. At the other end of the spectrum, a financial intermediary overly eager to achieve returns may allocate resources to highly risky assets that offer high returns but endanger stability. Explicit risk management practices can help in the selection of assets to which capital and other resources are applied and calibrate the level of capital that best suits business objectives and stability tolerance.
The size and composition of the resources that capital enables financial intermediaries to raise are likely to affect their profitability and stability. In a frictionless world where full information is available and markets are complete, the value of a firm would be independent of its capital structure, and so the focus should be on capital level and not structure.[6] Under such circumstances, the method by which a financial intermediary raises its required funds would be irrelevant. However, financial intermediaries do not operate in a frictionless world; they face imperfections such as costs of bankruptcy and financial distress, transaction costs, asymmetric information, or taxes. They also operate within the framework of a governing regulation possibly with a deposit insurance scheme that is expected to provide a safety net. In fact, one may contend that these market imperfections are the very reason for the successful existence of banks as financial intermediaries. Accordingly, not only a financial intermediary’s level of capital but also its structure is likely to bear on its market valuation, its business conduct, and its stability. Effective risk management strategies should contribute to a financial intermediary’s ability to assess not only the level of capital it would need in relation to assets and deposits, but also the extent to which its structure affects its value.
Market discipline contributes to responsible corporate behavior. Markets’ reactions to perceptions of a financial intermediary’s business conduct and capital strength may be unforgiving. It is thus in the interest of financial intermediaries to develop approaches to defining capital resource requirements that take into account the institutional environment in which they operate. The market’s perception of market imperfections is likely to influence views on the appropriate level of capital and the capital adequacy of financial intermediaries. For example, the availability of a safety net may lead market participants to be less demanding as to the need for capital in relation to bank assets. Conversely, anticipation of high costs of financial distress to depositors and other stakeholders may induce market participants to require the holding of more capital proportionally to assets. Similarly, wherever the institutional environment is weak and contract enforcement is uncertain and costly, markets may expect financial intermediaries to adapt the capital they hold.
The management of capital structure should in principle mitigate the risk of bank failures. When comparing a highly leveraged bank and a bank that is well capitalized, the leveraged bank will likely experience a greater loss of value during times of financial distress when the asset quality deteriorates, due to the increased risk of bankruptcy. To cope with downturns, in most countries banks hold a minimum amount of capital, based on the risk embedded in their asset holding. Accordingly, banks with relatively risky assets would hold a higher amount of capital than those banks with less risky assets. However, fearing the harshness of market discipline, many banks maintain a higher level of capital than the minimum required to allay the perception that they may be undercapitalized and avoid the losses this may induce, as witnessed in the 1980s. The key capital adequacy ratio provides an assessment of just how adequately the capital cushions such fluctuations in the bank’s earnings and supports higher assets growth.
Finally, efficient risk management should allow financial intermediaries to have a constructive dialogue with regulators. It would help them to articulate their views with respect to capital needs. The regulators’ rationale for regulating capital stems from the perception of the public-good nature of bank services, their potential macroeconomic growth and stability impact, and experience with costly bank failures. According to some estimates, such costs have varied between 3% and 55% of GDP.[7] Thus, regulators’ concerns with possible systemic risk resulting from the contagion effects of bank runs lead them to seek to mitigate risks of financial distress with regulatory requirements on banks’ capital.[8] Regulators’ concerns may be compounded by the presence of deposit insurance schemes. The moral hazard that may result from deposit insurance may lead to additional regulatory requirements such as linking the level of insurance premia to the risk embedded in assets and captured in associated risk weights. Indeed, deposit insurance may induce banks to lever up capital by expanding their own funding with liabilities, thus placing more risk on their capital and increasing their vulnerability. Efficient risk management practices would allow banks to improve their dialogue with the regulator and convey more convincingly their views on their soundness and capital requirements.
Regulators would generally also be concerned with the overall impact on the economy of the resources raised by the financial system under their purview. From an economy-wide perspective, banks may be viewed as firms’ competitors in raising capital on financial markets. The outcome of this competition has a bearing on economic performance and financial stability, and points to a cost–benefit tradeoff in holding capital. For instance, Gersbach (2007) suggests that a benefit of bank capital is the equity acting as a buffer against future losses, thereby reducing excessive risk taking of the banks. At the same time, raising bank capital may lead to a crowding out of industrial firms, limiting their access to equity and other market funding and also impacting their access to funding from banks and its cost. Furthermore, raising equity on markets may increase the cost of banks’ resources, inducing them to seek to invest in higher-yielding but more risky assets and thereby increasing their risk exposure. Thus, while potentially providing a cushion against unforeseen events, a higher level of equity may actually induce more risk taking, notably through raising the cost of funds to banks and their clients. Efficient risk management can provide inputs to both banks and regulators to better calibrate capital needs and deal with the foregoing type of tradeoff.
The level of a financial intermediary’s capital may also have a bearing on its ability to provide liquidity. The financial intermediary provides liquidity by funding assets that may be less liquid than the deposit resources it collects. There is a view that requirements for higher levels of capital may have a negative impact on liquidity creation.[9] On the liability side, a higher capital requirement may lead to a corresponding reduction in the level of deposits, thus constraining the ability to provide liquidity. Also, higher capital requirements may induce financial intermediaries to be more restrained in extending financing, thus constraining their ability to provide liquidity. However, according to another view, higher capital would allow the financial intermediary to create more liquidity since its risk-absorptive capacity would be improved.[10] In this regard, an empirical study concluded that for larger banks capital has a statistically significant positive net effect on liquidity creation, while for small banks this effect is negative.[11] Accordingly, each financial intermediary would need to evaluate carefully the level and composition of the capital it needs, since the latter plays a significant role in its ability to function as a liquidity provider. Equally, regulators would need to pay attention to the impact which capital requirement would have on the funding of the economy.
IIFS’s risk management arrangements will bear on their ability to calibrate capital to their business objectives and risk tolerance, to deal with market discipline, and to maintain a dialogue with regulators. The IIFS’s characteristic of mobilizing funds in the form of risk-sharing investment accounts in place of conventional deposits, together with the materiality[12] of financing transactions, may alter the overall risk of the balance sheet and, consequently, the assessment of their capital requirements. Indeed, risk-sharing “deposits” would in principle reduce the need for a safety cushion to weather adverse investment outcomes. Similarly, the materiality of investments is likely to modify the extent of their risk and have a bearing on the assessment for the overall need for capital; asset-based modes of finance may be less risky and profit-sharing modes more risky, than conventional interest-bearing modes. Nevertheless, IIFSs would operate within a regulatory framework that is likely to impose on them capital requirements with a view to promoting stability and limiting contagion risks. However, besides regulatory and market demands for IIFSs to hold capital, IIFSs need to put in place risk management assessments for their own purposes of returns and stability in accordance with the requirements of Shari’ah, their own mission statements, and the protection of their stakeholders.
[1] See Honohan (2004) and Levine (2004).
[2] Sir John Hicks identifies such liquidity as one of the main factors behind the Industrial Revolution.
[3] Actually, a deposit can be viewed as a purchase of a debt asset issued by the intermediary and redeemable at its face value.
[4] The institution–market competition is reflected in the trends of their relative market shares of total financial assets. For example, in the United States, between 1960 and the early 1990s, commercial banks’ share of total financial intermediaries’ assets fell from around 40% to less than 30%. See Edwards (1996).
[5] They do respond to a latent demand for financial services that do not breach Shari’ah principles. Accordingly, they have the potential to contribute to financial deepening, economic growth, and social inclusion. See also Burghardt and Fuss (2004).
[6] Modigliani and Miller (1958).
[7] See Klingebiel and Laeven (2007).
[8] Views differ on the need for and extent of regulation, as well as on the usefulness of deposit insurance; see Barth, Caprio, and Levine (2007).
[9] Diamond and Rajan (2006).
[10] Allen and Gale (2007).
[11] Berger and Bouwman (2005).
[12] By the “materiality” of financing transactions is meant that, in such transactions, capital must be “materialized” in the form of an asset or asset services (as in Murabaha credit sales, Salam and Istisna’a financing, or Ijarah leasing), or of a business venture (Musharakah or Mudarabah). Capital in the form of money is not entitled to any return, as this would be interest (riba).
…… to be Cont.
Sir Muhammad Faseeh ullah Khan
M.Phil(Eco+Banking and Finance);MBA;M.A(Eco.);MIT;PIPFA;B.Com e-mail:faseeh_u@yahoo.com
Article from articlesbase.com
Long-Term Financing Policy, Capital Structure, Risk Management Policy and Acquisition Analysis
Long-Term Financing Policy, Capital Structure, Risk Management Policy and Acquisition Analysis
Cooper executed several acquisitions to expand its business and broaden its diversification to gain market share. Cooper’s management was highly concerned about their need to diversify since they relied heavily on the sale of oil and gas tools to industrial customers.
Likewise, earnings volatility was caused by the cyclical nature of heavy machinery and equipment sales. Regrettably, the effort to reduce the earnings volatility for Cooper Industries was not successful since sales were entirely concentrated the same industry. By 1959, Cooper ceased operations in four of the acquired companies that broadened their market, yet they did not satisfy the need to diversify the company. In order to avoid any more ineffective acquisitions, Cooper developed three criteria that must to be met for all future acquisitions, Cooper Industries, Inc.- Case (1974). Industry choice should permit Cooper major player status · Industry should be stable and enable sales of “small ticket” items.
Industry leading firms would be acquired Only acquire industry leader Cooper implemented these criteria by acquiring Lufkin Rule Company in 1967. The new strategy would ensure that Cooper’s acquisitions benefited them and their shareholders. Cooper’s next step was to acquire Nicholson File Company [Nicholson]. This paper is going to further expand and analyze this acquisition. Meeting the Criteria Nicholson as one of the largest domestic manufacturers of hand tools, led in its two main products areas: files and rasps. It had 50% share of the million market for files and rasps where they had established excellent reputation for quality and brand name. Its hand saw and saw blades also had excellent reputation for quality and held a respectable 9% share of a 0 million market. Nicholson’s best asset, their distribution system, gave them a competitive advantage that was attractive to Cooper.
Aside from these attributes Nicholson was in financial trouble. Their common stock was trading at to per share well below its book value of .25 per share. The company reflected a low price-earnings ratio of 10-14 compared to 14-17 times earning for other leading hand tool companies. Every aspects of Nicholson’s business met the acquisition criterion that was previously established by Cooper.
Benefits of Acquisition
Cooper analyzed the benefits of merging with Nicholson. Cooper estimated that Nicholson’s cost of good sold could be reduced from 69% of sales to 65%. The acquisition would eliminate the sales and advertising duplication, which would lower the general and administrative expenses from 22% of sales to 19%. In addition, “75% of Nicholson’s sales were to the industrial market and only 25% to the consumer market” (page 5) compared to the inverse for Cooper, since they distributed between the consumer market at 25% and industrial market at 75%.
Synergies
Synergy can be defined as the value that is created by combining companies, which yields a result greater than the value of these companies as separate entities. It is important to recognize the synergy that existed with the two corporations. The acquisition would provide a greater marketability for both of these companies. Both of these companies will improve their profit margin by working together instead of as competitors. When companies are acquired, competition should be reduced giving companies better opportunities to advantageously control price. In addition, the acquisition will provide growth. With each of these product lines, both of these companies together can achieve greater sales expansion. Improved distribution methods by Nicholson to Cooper would reduce operating costs to the venture as a whole.
Capital Structure
Cooper Industries should structure the deal to finance the acquisition of Nicholson. Cooper has capital structure options to finance this acquisition. They can issue debt, arrange lease financing, bond swapping, offer preferred stocks, warrants, convertible bonds and callers. These selections offer investment options for Cooper.
“Typical financing decisions include how much debt and equity to sell, what types of debt and equity to sell, and when to sell debt and equity. Just as the net present value criterion was used to evaluate capital budgeting projects, we now want to use the same criterion to evaluate financing decisions” A five-year projection (Exhibit H) has been created to demonstrate the desired progress toward the projected goal of this acquisition in regards to the synergies. Appendix A illustrates the combined financial statements without synergies in detail. In 1972, the true effect of the acquisition is felt with the increase in net income and then leveling out as the year’s progress. Earnings per share were greatly impacted by 1972. This merger also impacts long-term debts. In order to acquire Nicholson File Company, Cooper Industries would have to look for a way of long-term financing, thereby increasing its debt and debt/equity ratio.
The Cooper/Nicholson acquisition has a positive impact on both companies and it is believed that the two companies have great synergistic value. The acquisition will not only reduce operating costs but it will also reduce additional selling and administrative expenses, as well. The SG&A expenses should decrease by 10% the first year and should experience no increase in them in years after. Revenue too had a 5% increase and it too stabilized into having a consistent increase of 8% every year. The 5-year projection after the acquisition provides a positive glimpse for the future.
Pursuant to due diligence, we have compiled the following report evaluating these financing options:
· Exhibit A Income Statement Balance Sheet without Synergies
· Exhibit B Income Statement Balance Sheet with Synergies Financing With Bonds
· Exhibit C Income Statement Balance Sheet with Synergies Financing with Cooper Common Stock
· Exhibit D Income Statement Balance Sheet with Synergies Financing with Cooper Preferred Stock
· Exhibit E Summary Combined with Synergies Financing With Bonds
· Exhibit F Summary Combined with Synergies Financing With Cooper Common Stock
· Exhibit G Summary Combined with Synergies Financing With Cooper Preferred Stock
· Exhibit H 5-Year Projection Income Statement and Balance Sheet
· Exhibit I Net Present Value Calculations
This team of authors recommends a bond issue as the preferred capital financing structure for a variety of reasons. Debt capital used more than equity capital causes a higher debt to equity ratio, partners.financenter.com (2004). As this ratio increases then the financial leverage of the business increases to a point. The maximum ratio of debt to equity is achieved when a firm can no longer service its debt. The inability of a firm to service or pay its debts is termed as insolvent. Debt capital, the assumed interest rate of 8% is used, with a twenty-year term and a sinking fund for future debt retirement over the term of the debt commencing in year one or 1972.
This usage of debt rather than equity to finance the acquisition of Nicholson causes a greater return on shareholder equity since the use of other peoples money (OPM) causes a magnification on return of the existing capital structure. If the Firm were to issue more stock in lieu of debt then the existing equity structure would be diluted and the return on shareholder’s equity reduced. The objective of the Firm would be to maximize shareholders’ wealth and debt-financing structure achieves the objective better than the issuance of more shares of stock. Another cause for debt issue for the financing is linked to the United States Tax Code allowing companies to expense interest expense as a financing expense accounted for in the statement of cash flows where it is deducted from net income before taxes prior to federal income tax calculation. The boon of tax benefit is not available in many other foreign nations where interest expense is not a tax preference item.
Therefore, the 8% interest expense will reduce net income before interest and taxes dollar for dollar and subsequent income taxes at 34¢ on the dollar of earnings before interest and taxes. Furthermore, as the Firm grows, the debt to equity ratio will probably change assuming profitability and the assumptions are mainly correct. As profits are generated over time and they are kept in the Firm in the form of retained earnings at that point in time will have dropped and the total equity in the company will have grown. This is exactly what most companies look for in a merger or acquisition.
Since the acquirer and Nicholson are both companies heavily laden with inventory and that inventory needs to be financed either by cash or accounts payable to the extent that this case was analyzed prior to the new Wal-Mart/Dell Computer method of working capital financing. In this model, the vendor does not bill the purchaser (Wal-Mart or Dell or the Firm) prior to purchase but the customer thereby avoiding the need to finance. In the case of the Firm, inventory is a requirement. Depending on the industry and to the extent that cash is generated by it leveraging is needed more or less. In other words, the more cash generated from operations the less leverage required during the operations of a company notwithstanding the acquisitions. To the extent that the bond underwriters will issue bonds and the bonds will be graded (priced) to the extent of the debt to equity ratio, solvency and future value is key.
That key is the cost of capital. The team of authors have assumed a rate of 8% annually flat over the 5 year pro-forma.
Guy McCord, MBA, CBC turnaround specialist with small closely held businesses, expert in consumer driven health plans, deferred compensation, asset protection, property and casualty insurance, commercial landscape, industrial staffing, staffing, dallas, fort worth, austin, houston, http://www.landstartexas.com
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One of the most important parts of the venture financing process is negotiating the term sheet. Although only 2-3 pages long, term sheets contain summaries of the critical aspects of a financing. Listen to a simulated negotiation between a VC and an entrepreneur, followed by a discussion on the most important terms. Recorded: February 25, 2009
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The Structure of a Venture Capital Investment By Abdul Razaq
The Structure of a Venture Capital Investment By Abdul Razaq
When a venture firm decides it is interested in investing in your company, it will offer you with a term sheet, which is essentially an offer letter. If you are a business owner than you conscious that one of your business challenges is getting your company funding. To put it simply, an investment firm will give money to a promoting company.
While this investment can be a tremendous boon to a tiny division of the companies pursuing it, in the vast majority of cases it presents the entrepreneur with a “Faustian Bargain”. I have come to understand that raising even a small amount of angel funding is a challenge. Venture capital investments normally are high risk investments but offer the potential for above average returns.
If you have gotten to this point without a good lawyer, now is the time to hire a qualified one with a background in venture capital finance. This investment firms will require a fair estimation of your business shares and then will acquire a set amount of shares at an agreed up price. Venture capital firms usually comprise small teams with technology backgrounds (scientists, researchers) or those with business training or deep industry experience.
The decision to chase venture capital is often a tempting distraction from the much more complex and important entrepreneurial tasks of producing something to sell and persuading someone to buy it. I still do not fully understand why my company, Oases, has not been able to raise capital, but I think it is just a substance of finding the right investor.
Article “The Structure of a Venture Capital Investment By Abdul Razaq”
Venture Capital Financing: Structure and Pricing
Venture Capital Financing: Structure and Pricing
Introduction
A venture financing can be structured using one or more of several types of securities ranging from straight debt-to-debt with equity features (e.g., convertible debt or debt with warrants) to common stock. Each type of security offers certain advantages and disadvantages to both the entrepreneur and the investor. The characteristcs of your situation and current market forces will impact the type and mix of security package that is right for you.
Types of Securities
Senior debt: Which is usually for long-term financing for high-risk companies or special situations such as bridge financing. Bridge financing is designed as temporary financing in cases where the company has obtained a commitment for financing at a future date, which funds will be used to retire the debt. It is used in construction, acquisitions, anticipation of a public sale of securities, etc.
Subordinated debt: Which is subordinated to financing from other financial institutions, and is usually convertible to common stock or accompanied by warrants to purchase common stock. Senior lenders consider subordinated debt as equity. This increases the amount of funds that can be borrowed, thus allowing greater leverage.
Preferred stock: Which is usually convertible to common stock. The venture’s cash flow is helped because no fixed loan or interest payments need to be made unless the preferred stock is redeemable or dividends are mandatory. Preferred stock improves the company’s debt to equity ratio. The disadvantage is that dividends are not tax deductible.
Common stock: Which is usually the most expensive in terms of the percent of ownership given to the venture capitalist. However, sale of common stock may be the only feasible alternative if cash flow and collateral limits the amount of debt the company can carry.
While each of these securities has unique characteristics, they can be grouped into two categories: debt or equity. In structuring a venture financing, the primary question is whether the financing should be in the form of debt or equity.
Disadvantages of Debt to a Company
From a company’s viewpoint, there are two potential disadvantages to debt.
An excessive amount of debt can strain a company’s credit standing, thereby reducing its flexibility in meeting future long-term financing requirements on a favorable basis. It can also negatively affect a company’s ability to obtain short-term credit. Of course, the form of debt the venture financing takes makes a difference. For example, subordinated debt will have less impact on borrowing capacity than senior debt.
The venture capitalist has the option of calling his loan if the company is in default of the loan agreement. This remedy, which is not available to him under other financing agreements, puts him in a better position to influence the company’s affairs when it is in default.
Advantages of Debt to a Venture Capitalist
From the venture capitalist’s viewpoint, there are three principal advantages to debt.
There is a greater likelihood that the venture capitalist will get his principal back and, at least, a small return. Many of the companies in the average venture capitalist’s portfolio are referred to as “the living dead.” Needless to say, their performance has turned out to be disappointing. In some cases, these companies are able to repay principal with interest but have limited appeal to potential acquirers or the public. As a result, a venture capitalist with an investment in such a company’s common stock may be unable to recover his investment within a reasonable period, if at all.
As previously discussed, under certain circumstances the venture capitalist is in a better position to influence the company’s affairs.
The venture capitalist has a senior claim. However, it should be emphasized that the meaningfulness of a senior claim depends on the marketability of a company’s assets and the amount of equity it has to cushion its creditors’ position. For example, in the case of a start-Lip situation with little or no equity, a senior claim means little or nothing.
Percentage Ownership Needed
While the difference may not be great, depending on the particular circumstances of the company, a debt position involves less risk than an equity position for the venture capitalist. Accordingly, a company should not have to relinquish as much ownership when a financing is in the form of debt. However, this advantage must be weighed against the disadvantages of debt.
No matter how the venture financing is structured, it must be priced so that it is attractive to the venture capitalist. There is no clear-cut answer as to how much ownership a company will have to relinquish to make a financing attractive. Broadly speaking, the greater the potential return perceived by the venture capitalist, the less ownership he will demand. In other words, if a company has a patented product which a venture capitalist thinks is revolutionary and highly marketable, he will undoubtedly settle for less ownership than he would in the case of 4 company with a relatively less attractive product. Thus, his ultimate position will be a business judgment based on his potential return.
Before you enter negotiations with the venture capitalist, you should determine what your company is worth and how much of your company you want to sell. The following procedure can be used to get a rough idea of how much ownership you will have to give up to make the financing attractive.
Estimate the risk associated with the venture financing. If the investment is very risky, the venture capitalist may be looking for a return as high as 15 times his investment over five years. Conversely, if a relatively low degree of risk is involved, the venture capitalist may be satisfied with doubling or tripling his investment over five years.
Make a reasonable estimate of the price/earnings ratio applicable to comparable publicly held companies. The market value of the company can then be projected by multiplying forecasted annual earnings by the estimated price/earnings ratio for comparable companies.
Divide the estimate of the total dollar return the venture capitalist wants by the projected market value of the company. This yields the percentage ownership the venture capitalist will need, as oil the future date, to realize his desired return. It is important to note that any equity financing required during the interim period must be considered in making these calculations.
Case Study
Suppose XYZ Company, Inc., a start-up, needs 0,000. The company’s product appears to have excellent potential. However, because the product is new and unproven, an investment in the company would be extremely risky. Accordingly, it is reasonable to estimate that a venture capitalist would want a potential return of at least ten times his total investment in five years. Management estimates that the company should be able to “go public” at 20 times earnings in five years. Projected after-tax earnings for the fifth year is ,250,000. Additional long-term financing of 0,000 will be needed at the beginning of the third year.
Scenario I
In the calculations below it is assumed that the venture capitalist who provides the initial financing (0,000) also provides the subsequent financing (0,000), and that he wants a return equal to ten times both. However, it should be noted that if the company made satisfactory progress during the first two years, it would be reasonable to assume that the venture capitalist would be satisfied with a lower return on the subsequent financing since it would involve less risk.
Estimate of Total Dollar Return Required Total Investment $ 1,000,000 Estimate of Return Required X 10
,000,000
V. Projected Market Value in Fifth Year VI. VII. Projected Earnings ,250,000 VIII. Estimate of P/E Ratio x 20
,000,000
Percentage Ownership Needed in Fifth Year Estimate of Total Dollar Return quired ,000,000 Projected Market Value of Company in Fifth Year 25,000,000
40% Scenario II
In this set of calculations it is assumed that a second investor provides the subsequent financing (0,000). The calculations show that the venture capitalist who provides the initial financing (0,000) would need 20% ownership as of the fifth Year to realize the return he wants. However, since the ownership to be given up for the subsequent financing will reduce his ownership position, he will want more than 20% ownership initially. For example, if it is assumed that 15% ownership will have to be given up for the subsequent financing, the venture capitalist who provides the initial financing would need 23% ownership initially to end up with 20% ownership in the fifth year.
Assume the same facts as Case I, except a second investor provides the subsequent financing for 15% ownership.
Estimate of Total Dollar Return Required Total Investment $ 500,000 Estimate of Return Required X 10
,000,000
Projected Market Value in Fifth Year Projected Earnings ,250,000 Estimate of P/E Ratio x 20
,000,000
Percentage Ownership Needed in Fifth Year Estimate of Total Dollar Return required ,000,000 Projected Market Value of Company in Fifth Year 25,000,000
20%
Thus, it appears that the investment (0,000) may be attractive to an interested venture capitalist if the principals of XYZ Company, Inc. are willing to give up approximately 23% ownership.
Conclusion
It must be emphasized that the above procedure is highly subjective. And, you should remember that what really matters is how the venture capitalist views the relative attractiveness of a company. Typically, venture capitalists are satisfied with a minority interest. Although a venture capitalist may demand a majority interest, generally they are not interested in operating control. Some of them like to tie the amount of ownership they ultimately get to the performance of the company. For example, a venture capitalist who wants a majority interest initially may give the principals the opportunity to earn part of it back. Such an arrangement can be used to compromise on pricing when there is a significant disagreement between the principals and the venture capitalist.
To entrepreneurs unfamiliar with venture capital, it may appear that the venture capitalist is seeking an extraordinary high return on his investment. However, it is important to understand that, even under the best of circumstances, only a minority of the companies in which the venture capitalists invests will be successful. He is well aware of this, and must make a sufficient return of his successful investments to come out with an acceptable return overall.
Alan is managing partner at Greenstein, Rogoff, Olsen & Co., LLP, a leading CPA firm in the San Francisco Bay Area. Alan has more than 23 years of experience in public accounting, and works with some of the most successful venture capitalists in the world, helping to develop innovative financial strategies for business enterprises. Alan earned a B.S. in Accounting from Brigham Young University, and an MBA (Taxation) from California State University at Hayward.
Finance Options for Business. Find out about what finance options are available to your business – whether you’re just starting up or planning to grow. A fully accessible version of the video, together with transcripts will be available shortly at www.businesslink.gov.uk
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