Summary
The G20 meeting has agreed that banks need to be properly capitalized with equity instruments as compared to hybrid debt-equity. A number of other changes in the capitalization of banks is also proposed. This would mean that debt instruments with characteristics of equity would have a bleak future in the capital structure of banks. In this analysis I highlight some of the issues involved in this conundrum.
Analysis
1. The capital structure of financial institutions has always been a challenge for accountants and analysts. This is because it is so dissimilar from the financial structure of manufacturing and trading entities.
2. The fact that financial institutions have to trade on equity as a matter of routine in order to run their business efficiently makes them more vulnerable to the ill effects of financial leverage in a downturn.
3. The G20 proposal to force banks to have a higher level of equity seems ill conceived and would strike at the very root of the business model of these institutions.
4. At the same time accountants and analysts would have to start getting confused with how to analyze the financial statements of these entities - as manufacturing/trading entities or as banking institutions.
5. The valuation of equity instruments and hybrid debt-equity is also a challenge for accountants. The proposals of the G20 would create further problems in this area.
Nitish Grover consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
