There are three common ways a bank may be able to raise finance:
(1) Retained earnings/ plough back of profits. (2) By borrowing, that is debt financing. (3) By selling stock/shares that is equity financing.
Each method has an impact on the structure of the bank’s balance sheet that is advantages and disadvantages.
A firm can finance projects by ploughing back its profits. By paying out less of its profits in dividends, the company can keep more of its profits as retained earnings and use them to fund its investments. Using retained earnings to finance projects appeals to managers because they can avoid paying interest. However, the shareholders may not like it if their dividend becomes smaller. Also, sometimes the firm needs more money for a particular project than it has available in retained earnings.
A bank can also choose to borrow money to fund its activities. A bank can either borrow from a bank (long term or overnight borrowing). Such a source is costly because high rates of interest are charged and many legal restrains are imposed on the bank’s operation and freedom of trade (restrictive covenants). Borrowing directly from investors by issuing bonds and debentures is yet another method; a bank can also borrow from the Central Bank also.
Although a firm must pay interest if it borrows money, it can deduct the interest from its profits and therefore pay less in taxes this is because interest is tax deductable. However, there are limits to how much a firm can borrow and too much borrowing could lead to bankruptcy. Debt financing is quite costly because of the interest charged and since the lenders require collateral security, it must be repaid, it increases leverage which decreases profitability, have fixed maturity periods, some are negotiable. Banks frequently raise money in overseas financial centers.
Selling stock is another good way a banks can raise funds. Unlike a loan, the funds received from the sale of stock belong to the company (equity capital) and do not have to be repaid, they are long term, are cheap, do not lead to liability. As a consequence, the banks do not have interest expense on this finance tool. However, the firm must still earn a certain return on its investment to obtain the cash to pay dividends or devote to retained earnings. Banks also may not want to issue stock because the costs of issuing stock, such as fees for legal and other legal services, are usually higher than for issuing bonds.
It is also important that we consider factors other than cost when deciding how to raise money. For example, if a bank tries to raise new funds, the public will speculate about the bank’s plans before buying such stocks. If investors think the plans are a bad idea the bank’s stock price could fall. Lending firms will look at the equity-asset ratio and d the bank’s performance trends and patterns.
Debt financing as indicated usually reduce the bank’s profitability. Their risk is that they put the assets of the bank at stake and in case of default of repayment by the bank; lenders may put pressure for liquidation. Heavy reliance on debt finance sometimes may be costly especially in periods of deflation. Equity finance is the most secure risk free and faultless source since it does not call for its repayment.
- Myers C. and Richard. (1981).Principals of Corporate Finance, 3rd McGraw-Hill Book co.: Singapore.
- “Finance.” Microsoft® Encarta® 2006 [DVD]. Redmond, WA: Microsoft Corporation, 2005.
- Jane W.D’Arista.(1998).The evolution of U.S finance,M.E.shape.Amazon publisher