1. WORD OF GRATITUDE
2.1. Purpose of the research
2.2. Nature of the research
2.3. Approach of the research
3. LITERATURE REVIEW AND ANALYSIS
3.1. Corporate financing strategies
3.2 Basel III and its expected impact on commercial banks
3.3. Expected impact of Basel III on corporate financing
3.4. Research gap
4 CASE ANALYSIS AND STRATEGY IMPLICATIONS
4.1. Expected reaction of banks - Deutsche Bank AG case
4.1.1. Development of key financial indicators of the DB AG at the group level
4.1.2. Outlook for commercial banking products terms of the DB AG
4.1.3. Comparability with similar commercial banks
4.2. Resulting impact on corporate financing – BMW AG case
4.2.1. Current financing structure
4.2.2. Development of cost of debt capital
4.2.3. Comparability with similar auto-producers
4.3. Strategy implications
4.3.1. Outlook: is there a need for a change in financing strategies?
4.3.2. Adjusting the business for a wider market participation: recommendations for overall company strategy
In response to the recent financial and ensuing economic crisis of 20072008, the Basel Committee on Banking Supervision announced a new set of measures - Basel III, which ought to create a more resilient banking system. It also intends to help contain adverse effects of financial system from spilling over to real economy. This, in turn, will allow real sector of economy avoid potential credit disruptions in future.
However, just as a coin has two different sides, Basel III might also have unintended adverse effects on real sector. Therefore, this research is addressed at analyzing possible effects of the new regulations on corporate financing.
Through review of relevant literature, we have been able to identify the most significant researches in the area to date. On one hand, advocates of Basel III argue for a substantial net economic advantage of around 2.6 per cent of annual GDP increase as a result of implementation and imply that society will be better off as a result. On the other hand, there are a number of critics, who state that prescribed tighter and liquidity requirements will create a two-side pressure on RoE of banks, prompting these to allocate less capital to lending business - thus decreasing credit, available to real economy.
As a result, after conducting two case-studies: one a bank and another on a non-financial corporate, it has been determined that, on one hand, larger banks, using market leadership position, relatively bigger size and also given efforts, directed at reduction of operational costs will be able to limit price increase of most of commercial banking products. On the other hand, it is defined that this is the right time for non-financial corporates for a wider direct financial market participation. In general, this paper extends support for the new banking regulations given a proper implementation.
As a closing point, a recommendation on how to best perform this strategic shift from traditional banking products to financial market products was proposed.
Keywords: Basel III, corporate finance, strategy tools
- LIST OF TABLES –
Table 1. Summary of regulations, proposed in Basel III Source: Original summary of Basel III reforms (2013)
Table 2. Development of net income of DB AG (in million)
- LIST OF CHARTS -
Chart 3.1. Proportions of internal and external funding in selected countries
Chart 3.2. General structure of external financing tools
Chart 3.3. Proportions of equity and debt in total external financing
Chart 3.4. Dynamics of capital adequacy rules14%
Chart 3.5. Basel III will vs. will not accomplish
Chart 3.6. Additional funds required from Basel III implementation
Chart 3.9. Average market capitalization of domestic Companies in percentage of GDP
Chart 3.10. Structure of corporate finance market: cross-country analysis
Chart 3.12. Estimation of maximum equity capital needed for Basel III and net profit (in billion)
CHART 3.13. SHARE OF BANK GROUPS IN GERMAN CORPORATE FINANCING MARKET
Chart 4.1. Divisional structure of DB AG
Chart 4.2. Brief description of core units of DB AGCorporate Banking & Securites
4.3. Development of interest income and interest expense of the DB AG
4.4. Development of loans, assets and total shareholders' equity of the DB AG (in billion)
4.5. Development of outstanding loans of DB AG to selected industries (in billion)
4.6. Development RoE of DB AG
4.7. GTB's German market share in trade finance
4.8. GTB's worldwide trade finance nominal volume (in billion)
Chart 4.9. Operational divisions of BMW AG
4.10. Structure of financial liabilities of BMW AG (in billion)
4.11. Development of debt capital cost of BMW AG (in million)
Chart 4.12. Moving from ideas to execution
- LIST OF ABBREVIATIONS -
illustration not visible in this excerpt
1. WORD OF GRATITUDE
Current master thesis report can be viewed as the logical finish line of my MBA studies at the Coburg University of Applied Sciences, which I started in October of 2011. I consider this report to be containing academic knowledge and practical skills in the field of finance and management, which I was able to gather all the way through three academic semesters and the internship term. Indeed, it has been a very fruitful learning experience, which is not merely limited to financial field. This experience would certainly be much poorer without people, who have surrounded me, who have shared their knowledge, who have, in fact, lived through this experience together with me. Therefore, I want to take this opportunity and express my sincere gratitude to the following people:
My family, sense of my being - for their continuous support and motivation;
German Academic Exchange Service (DAAD) - for the opportunity and their trust;
Professor Dr. Victor J. Randall - for sharing his knowledge and showing his support during writing this thesis report;
Members of the “Institute of Lifelong Learning” at the Coburg UAS - for their enthusiasm and tireless efforts to ensure solution for all possible questions;
Managers and colleagues from Functional Controlling Europe department at the Deutsche Telekom AG - for their contribution in my development, both personal and professional;
MBA fellow mates - for the fun of the time, we have spent together, for new friends.
2.1. Purpose of the research
The most recent financial and ensuing economic crisis of 2007-2008 has proved just how much the world has become intertwined in many different ways. It is now not only financial sector and real economy of a single nation that are highly interlinked. Economies of many nations around the world are bound together in a way that any risk or opportunity, born in one economy is easily and swiftly transferred to several other economies. What we have also witnessed in the recent turmoil is that how big financial service industry has grown as part of gross domestic product1. Greed and moral-hazardous attitude of financial institutions were among the drivers of this unbelievable growth in size of financial sector up to 2007, particularly in the United States (next: US). Backed by these two factors, financial institutions (e.g. Bear Stearns, Lehman Brothers and many others) have compounded, on or off their balance sheets, huge amount of toxic financial assets with unjustified risk levels such as e.g. mortgage collateralized debt securities (next: CDS). As a result of poor risk management in terms of inadequate capital as well as liquidity reserves, in combination with high interconnectedness and the market shock (i.e. burst of housing bubble in US), these financial institutions started collapsing one after another. Several of them were subsequently bailed out by the US government. However, one of the biggest investment banks - Lehman Brothers was allowed to fall down due to ever more criticized too-big-to-fail policy. This has sent a very strong shock not only through the US economy itself, but also has shaken several dozen economies all over the planet. In particular case of European banks, damage was not limited only with direct financial losses from sharply devalued securities, but also systemic uncertainty and subsequent dried-out interbank lending caused a massive disorder in the European financial system. This, in turn, resulted in a radical cut in credit, made available to real economy, leading to decreased investment, slowed global trade and sharp increase in unemployment. All this combined has ensued the worst economic downturn, the world has seen since the Great Depression of 1930’s.
In response, the Basel Committee on Banking Supervision (next: BCBS), building on previous regulation accords such as Basel II, has in December 2010 announced a new set of reform measures - Basel III. In May 2012, the Council of the European Union has agreed on proposals of the European Commission to implement Basel III at the EU level2, effectively bringing the new accords into strength for banks in the European Union (next: EU) beginning from January 2013. These rules and regulations were updated with account of lessons, learnt from the most recent financial and economic crisis and are mainly intended to: strengthen banks’ capital base; improve their liquidity positions; increase transparency level of banks; harmonize and improve monitoring tools for banking supervision.
Addressing micro bank-level risks as well as macro systemic risks, successful implementation of Basel III ought to create a more resilient banking system in Europe. It will also help contain adverse effects of financial system from spilling over to real economy through enabling banks absorb future external shocks. This, in turn, will help real sector of the economy - small and medium-sized enterprises (next: SMEs) as well as large corporations avoid potential credit disruptions in future and build on sustainable economic prosperity.
However, just as a coin has two different sides, Basel III might also have unintended adverse effects on real economy. As it will be discussed in upcoming sections of this report, implementation of Basel III by European banks might result in changes in credit market and price of banking products, offered to the real economy. Encountered by these modifications, SMEs and corporates may have to make several changes in their financing strategies.
Particular effects for European SMEs have already been discussed in several research papers and articles, which generally conclude a negative implication due to increased financing costs and limited amount of alternative financing options. Therefore, purpose of this report is a critical analysis of possible impacts of Basel III on larger European corporations.
On the example of the Deutsche Bank Aktiengesellschaft (next: DB AG / the bank) and the Bayerische Motoren Werke Aktiengesellschaft (next: BMW AG / the corporate), this research will:
analyze how the implementation of the updated set of banking regulations will change the structure of the balance sheet of the bank;
asses how these changes will be subsequently reflected in terms of products, which the bank has on offer;
analyze current corporate financing structure in view of Basel III implementation;
evaluate alternative financial market solutions for financing needs of the corporate;
check on possible changes in capital raising strategies, the corporate will have to make as a result;
finally present recommendations for how best the corporate can manage these changes in strategy.
After reaching certain interim milestone conclusions, the report will try to draw a parallel between developments in these two companies with possible developments in other similar companies in respective sectors. It will enable readers to evaluate a possibility of industry-wide generalization of results.
When it comes to intended audience of this report, critical analysis of the situation and proposed strategy recommendations might be of interest to:
representatives of financial service industry;
representatives of real sector, in particular auto-producing corporations;
representatives of regulative bodies;
researchers as a starting point of a larger-scale study and future evaluation of actual developments, compared to conclusions of this report.
In addition, even though financial terms are described and explained throughout this thesis report, the author assumes that the reader possesses a certain level of knowledge and experience in the financial field in order to best grasp the ideas presented herein.
2.2. Nature of the research
Derived from the subject in question, the nature of this paper is defined as “applied research”3. It will evaluate the given situation (i.e. implementation of Basel III) with subsequent elaboration on implications of this situation on defined subjects (i.e. capital-raising strategies of BMW AG). Although where necessary, links to a general theory will be made, the research is intended to produce a contribution to practical knowledge rather than to theoretical.
It is the intention of the author that the research captures a practical situation and through critical analysis provides the audience with relevant results, and what is more important with applicable recommendations.
2.3. Approach of the research
Critical analysis, bringing relevant results as well as proposing applicable recommendations will be carried out through conducting two case-studies, namely one on the bank and another on the corporate.
In case of the bank, after putting Basel III briefly in perspective, recent development of key financial indicators over the last three complete financial years, i.e. 2010-2012 will be analyzed using its financial reports for respective periods. As a next step, specific examples of bank’s products, particularly in trade financing, will be brought into light. Building on these, an outlook for banking products in the light of the Basel III implementation will be anticipated. With resulted interim conclusions, a possibility of industry-wide generalization will be discussed.
Turning the research’s focus towards the corporate at this point, its current strategies of capital-raising will be reviewed based on latest financial and non-financial information. This way, role and importance of traditional banking products for the corporate will be evaluated. To complement the picture, alternative financing options directly from financial markets will also be considered.
Moreover, the development of the cost of debt capital of the corporate will be analyzed to see if the preparation of the country’s banks for implementation of Basel III had an effect on this key indicator of the corporate. An industry-wide generalization of the results to other similar auto-producers will be deliberated at the end of this section.
Deriving from results of the aforementioned analysis, a question of whether there is a need for change in financing strategies of corporate, in general, will be covered. In addition, through discussing wider strategy implications, a list of recommendations will be proposed, in order to enable corporates to best manage the anticipated strategic changes.
3. LITERATURE REVIEW AND ANALYSIS
This part will mainly focus on review of literature for those topics, around which this research will center and on critical analysis of these topics. First, an overall discussion of commonly accepted corporate financing strategies will be offered. This discussion will be complemented with a number of real-life data in order to keep the practical focus. It will be followed by discussion of new Basel III accords and results of relevant researches, which have tried to analyze their possible impact on commercial banks. The section will be rounded up with a review of researches, which have been already completed to analyze the relationship between Basel III and corporate financing.4
3.1. Corporate financing strategies
Before going into exploring different financing strategies for corporates, it is Companies in Europe, which have more than 250 employees and achieve an annual revenue of over 50 million EUR are considered to be a larger corporation or simply a corporate5. In this light, corporates have two primary sources for financing their operations:
internal funds - capital, which is created by past or current operations of a company and can be used to finance the firm;
external funds - capital, which is provided to a company by external participants, which operate in capital markets. ExempiT grätiä, in form of bank loans, corporate equity and bonds.
A choice between internal and external capital in financing a company is driven by a number of factors such as financing principles of a specific corporate and level of development of capital markets in the country, where it operates. The following chart 3.16 illustrates proportions of internal and external funding in total financing of a company in several countries around the planet.
Chart 3.1. Proportions of internal and external funding in selected countries It is important to mention though that this chart shows financing not only for corporates for also for SMEs.
It is interesting to observe in this chart that in Europe itself, company- financing patterns differ significantly across countries. If companies in Italy heavily rely on outside financing with 78 per cent of total financing coming from external sources, companies in Germany and Sweden use about the same level of internal and external funding with 46:54 per cent and 57:43 per cent respectively. On the other hand, internal financing is preferred by firms in the United Kingdom (64-36 per cent) and France (69:31 per cent). At the same time, companies in the US, for example, do have some similarities with German and Swedish companies in terms of financing sources with 53:47 per cent. Among other factors, these proportions are certainly effected by ability of companies in these countries to generate own, internal funds, which can be then used to refinance further operations and investments. In this perspective, it is not surprising that emerging markets such as China, for example, have one of the highest internal funding ratios.
Questions of internal financing being relatively straightforward, external financing issues offer a much wider challenge for company financial managers. In particular, in countries with developed financial markets, managers are often confronted with different categories and types of financial instruments, through which external financing is obtained. The following chart 3.27 illustrates a general structure of these instruments.
Chart 3.2. General structure of external financing tools Detailed description and usage of these instruments will be provided in the next sections.
One of the general categories of external financing tools is equity. Companies obtain financing by issuing and selling stocks (i.e. shares in company’s assets and profits) to either private or public investors. Stocks usually can take the following forms:
Common stocks - a type of equity tools, which entitles the owner to a respective share in company. Stockholder has a voting right in a company as well as a right for part of the company’s profit, proportionate to number of shares owned. This part of a profit is usually received once other respective obligations of a company are settled. Profit on common stocks is subject to a double tax: on corporate and on individual stockholder levels.
Preferred stocks - this type of equity gives a priority right to claim part of company’s profit before common stockholders, however after claims of debt holders of the company. Terms of issuance of such stocks differ from one issuance to another and usually do not have voting right attached and are sometimes sold with fixed dividend return rate and maturity date. This way, this hybrid instrument can take characteristics of both equity and debt. This chameleon feature of the instrument is the main reason why companies issue them (e.g. for improving leverage ratio) and investor buy them (e.g. for enhancing capital adequacy of institutional investors). In some cases, preferred stock may be issued with a right to convert it into a common stock8.
Warrants - this instrument is an equity call option, which gives its owner a right, but not an obligation to purchase company’s stock at a pre-specified price and time. Often, warrants are attached to debt instruments to “sweeten” the deal for debtors of a company.
Company stocks are first issued and sold in primary markets, often with an investment bank intermediation. They are then widely traded in secondary financial markets by institutional and private investors.
Another general category of external financing is debt. As it can be observed also in the chart 3.2, an array of debt instruments is much wider in comparison to equity instruments. Alike with equity, debt can be obtained from private and public sources and is first issued in primary markets, later to be traded in the secondary.
Whereas debt financing can take many different forms, the following debt instruments are the most relevant to this research:
Bank loans - the oldest and the most fundamental instrument of debt financing provides corporates with funds for a specified time period, be it short or long-term and for a price (i.e. interest rate on loan). It is not rare when banks require certain amount of collateral as a security in case of non-repayment as well as impose several covenants / restrictions on the company-borrower. The two commonly used types of loans are: 1) simple credit, where a certain amount of funds are lent and repaid over a certain period of time with interest payments; 2) line of credit, where a total “frame” amount of available loan is specified in agreement, enabling the company borrow up to this amount. Line of credit can also have a “revolving” feature, where company may repeatedly borrow and pay funds back within the total amount over a specified time horizon.
Another important issue related to a bank loan is its price, reflected in interest rate, which a company-borrower has to pay to its bank for being able to use the funds. The interest rate for a loan can be: 1) fixed, where bank charges a concrete annual fixed price on its loan, e.g. 7 per cent annually; 2) floating, whereas interest rate is set as a “benchmark rate plus a fixed spread”. Benchmark floating rates are considered to be relatively risk-free for this purpose and increasingly associated with yields on AAA-rated government treasuries (e.g. US, UK and Germany)9. In its turn, fixed spread depends on a number of risks associated mainly with the borrower’s credit history, liquidity, capital adequacy, profitability and its country of operation. These risks are usually reflected in company’s credit rating.
Commercial papers - mostly short-term contracts (from one month up to about one year), where a company borrows specified funds with an obligation to repay the amount in specified time with a certain interest rate on top. Growing rapidly over the last 20 years in market size, about two-thirds of commercial papers are issued by financial service providers and the rest is issued by “highest-quality non- financial corporations”10. The main role of commercial papers for corporates is to provide short-term liquidity for their operations.
Corporate bonds - longer-term debt contracts usually from one year up to thirty years, where an issuing company obliges to pay fixed periodic coupon payments11 in addition to a face value payment at maturity. Corporates traditionally sell bond contracts to cover their long-term investment projects12. Bonds can be sold with different options to favor both issuing companies as well as investors. A “callability” feature, for example, enables the company to refinance its debt in case of general decrease of interest rates. The other way round applies to bonds with “putability” option, which favors buying investors.
Leases - this debt instrument is used to enable a company-borrower (or a lessee) to exploit a leased asset (anything from computer, furniture up to high-technological equipment) for its operational needs, in return for fixed periodic payments to an owner of the asset (or a lessor). Partly driven by operational advantages for the company-borrower, due to the fact that there is no need for initial investment to purchase an asset, the leasing market has grown significantly since the second half of the twentieth century. Total amount of leased assets in Europe in 2009 approached 686 million EUR, highest stakes belonging to Germany with over 143 million EUR, followed by Italy and UK with over 128 million EUR and 92 million EUR respectively13. After a moderate cool down of the market, explained by the overall slowdown of economic activity after the crisis, the value of European leasing market in 2010 was just over 674 million EUR. The lion share thereof was in such assets as vehicles (30%), equipment (15%) and real-estate (5%)14.
Supplier credit - a type of debt financing, equally beneficial for a debtor as well as a company-borrower, is sales on credit. Either a short-term, revolving trade credit or a long-term equipment credit, this instrument benefits the borrower in terms of available-for-use asset with deferred payments as well as the supplier in terms of increased sales and liquidity over a certain time horizon.
In addition, V. Cunat15 in 2007 analyzed how short-term supplier credit, or simply trade credit may play an effective role in efficient debt collection and also help company-borrowers avoid liquidity shocks.
Other structured debt instruments: asset-backed securities (next: ABS) - this structured debt instrument allows a company-issuer to obtain external financing by securing its obligation with a set of future cash flows from exploiting its physical asset. The most popular form of ABS until the recent burst of US housing bubble in 2007 was mortgage-backed securities. However, potential of this contract stretches beyond mortgages and is widely applied also in the auto industry, particularly by BMW AG, which will be covered later.
Optimal capital structure
Issuance of equity is a first step of establishing a firm. However, external financing instruments used further down the road of company’s development is driven by numerous factors such as:
general interest rates in an economy;
conventions of management;
settling of conflicting issues between stock- and bondholders;
covenants imposed by existing debt contracts and others.
While there is no golden answer as to what the proportion of equity and debt in total capital should look like, the optimal capital structure must be a combination of equity and debt, which minimizes weighted average cost of capital (next: WACC) of a corporate and thus should help maximize the shareholders’ value16.
Assumed that companies around the world strive to achieve minimization of WACC, a country factor is also a driver of different structures of capital. The following chart 3.317 shows proportions of equity and debt in total external financing of companies in selected countries.
Chart 3.3. Proportions of equity and debt in total external financing
From the perspective of European companies, bank loans make up a lion share of external financing. To a bigger extent in Spain, Italy and Sweden, to a lesser extent in France and the UK, bank loans prevail over equity financing. Companies in Germany, however, prefer more equity rather than bank loans. This is partially explained by conservative conventions of German entrepreneurs, who rely more on internally generated funds as well as shareholders’ capital and do not prefer higher leveraged operations. It certainly does provide a better platform for a more stable business, thus an opportunity to have a reasonable forecasting ability. However to a certain extent this convention limits the opportunistic behavior of businesses.
It is also noteworthy to mention that supplier credit as a way of financing a company is also quite popular around the world. It does indicate the growing importance of this financial instrument in financing companies around the world due to the advantages, which it provides both to the customer and the supplier.
Logically, loans from development banks have been massively obtained by companies mostly in developing countries such as Czech Republic, Croatia and Armenia, but also in Germany, Canada and the US. In case of developing countries, these funds are then used to finance nationwide infrastructure projects such as building highways, railroads, intercity transportation, and delivery of natural gas, electricity and drinking water to far located communities. Proper implementation of these projects does not only increase general level of living standards in these countries, but also contributes to a radical improvement of business conditions therein.
On the other hand, a comparison of combined share of debt instruments versus equity clearly indicates that debt financing does prevail. It is partly explained by relatively lower transaction costs associated with obtaining a bank loan and issuing a debt instrument18.
While developing corporate financing strategy, which will have to maximize shareholders’ value, several other factors must also be considered. The followings are the most relevant in the framework of this paper:
Legislative environment of a market, where financing is to be raised is an important issue that defines corporate financing strategies.
In countries with common law in place (e.g. UK, US), corporates can react to market shifts in a more agile way, because of the more flexible legal system which is based on interpretation of current situation. Additionally, a research has concluded that in countries with common law, rights of investors are better considered and protected, thus widening financing opportunities in capital markets19. In countries with civil law, on the contrary, where the legal system is based on strict set of rules (e.g. Germany, France, and Uzbekistan) which can only be changed or adapted with a certain time lag, corporates may find themselves in a less flexible position, thus opting for more traditional financing strategies such as bank loans.
Another paradigm of financing strategies must be applied in countries with a religious legal system, e.g. in Saudi Arabia or in Iran with Sharia laws in place. In these legal systems most of the features of traditional Western financing are prohibited. For instance, interest rate on a loan or “riba” in Arabic language is labeled “haram” and is prohibited. However, scholars of ever-developing Islamic financing have been creating innovative product lines both to satisfy legal requirements and to provide borrowers with financing on competitive terms. Traditional corporate bonds, for example are replaced with “sukuk”, whereas “murabaha” does present a reasonable replacement for a third-party financing20.
Corporate ownership structure is in many cases a decisive factor, which defines overall corporate strategy, including financing. An observation of ownership structure of 20 corporates in selected countries by researchers21 has determined that corporations in such countries as UK, US and Japan have wider investor base with no single major shareholder. This structure may prefer short to middle- term maximization of shareholders’ value (i.e. 1-5 years) through investment in highly profitable / risky projects, at the same time providing managers with a greater role in defining company objectives.
On the other hand, corporations in Austria, where the government holds a prevailing share, might have a more development-oriented approach to business.
In addition, corporations in Belgium, Greece, Portugal and Sweden with a dominantly family-owned ownership structure, do have objectives, which are directed at development of a company over a longer term.
Ownership structure does not only predefine overall corporate strategy, but it also has implications on funding strategies. Careful selection of financing strategies, which best suit overall objectives will help managers better meet shareholders’ expectations and thus increase their satisfaction.
Banking-based vs. market-based systems - type of a financial system obviously plays a paramount role in forming corporate financing strategies. A research shows that even though a period from 1983 to 2007 is associated with a general deepening of both systems around the world, high-income countries have been on the forefront of market-based system expansion. Whereas low and lower-middle income countries have received substantial amount of repatriation funds. The research also concludes that “recent increasein cross-border lending and debt issues has been concentrated in high-income countries”22.
The aforementioned expansion of cross-border financial transactions can be associated with establishment and development of “Euromarkets”.
Euromarkets allow multinational corporates to finance their operations worldwide in virtually any freely-traded currency. Financing may take a form of a Eurobond (e.g. a German corporate operating in Switzerland issues Eurofranc bonds) or a Eurodollar loan (e.g. an American multinational receives Eurodollar line of credit by an international bank, both operating in China). Euroloans also allow numerous subsidiaries and / or daughter companies of international corporates to access loans with less transaction costs at approval of the headquarters. In this fashion, these subsidiaries and daughter companies will not have to inquire loan facilities separately each case, rather send an inquiry to a parent company, which is more aware of the operational details and can approve the loan with fewer costs and less time spent on each transaction. It also provides increased security for the bank, which issues a loan, because the bigger and more stable parent company is now its counterparty.
In these times of high uncertainty, only the financial manager with a profound knowledge of financial markets, its participants, products and recent trends is capable of providing the company with the financing, which will best meet its objectives. Below are the key findings of the literature review and analysis on corporate financing strategies, which can help achieve this goal:
1. External financing may be obtained both from private and public sources through two general categories: equity and debt financing.
2. Main equity financing instruments include: common stocks, preferred stocks and warrants.
3. Preferred stocks may be issued by corporates to improve leverage ratio.
4. Main debt financing instruments include: bank loans, commercial papers, corporate bonds, leases and supplier credit. There are also some exotic debt instruments such as asset-based securities.
5. Supplier credit may be an efficient instrument for debt collection and avoidance of liquidity shocks of a company-borrower.
6. There can be no fixed proportion of debt and equity, which promises overall efficient financing. However, in order to maximize shareholder’s value, corporate capital structure must be such, that minimizes weighted average cost of capital.
7. Partly due to its relatively lower transaction costs, debt instruments are more populär among Companies around the world.
8. Important factors that define an efficient corporate financing strategies are legal environment, ownership structure and type of financial system.
9. Euroloans, obtained in Euromarkets provide opportunities for multinationals to improve capital access and lower transaction costs for its international subsidiaries - thus improving the group performance.
3.2 Basel III and its expected impact on commercial banks
Since its publishing in December 2010, the new set of comprehensive banking regulations, named Basel III has attracted wide attention of researchers, field experts and public around the world. Advocates of the accords believe that the new regulations will help minimize future systemic risk in financial industry and that macroeconomic benefits are by far bigger than costs23. On the other hand, opponents of the rules fear unintended reciprocal impact and doubt that Basel III is a panacea for all problems. Some even propose to replace these regulations with a more flexible version24. At the same, there are also experts, who think that a due implementation of Basel III, coupled however with a coordinated efforts of banks and governments to adopt changes to banking business models will bring desired effects25.
So, what is Basel III? What are the main pillars of these regulations? What changes do they anticipate for banking business? This and more is discussed next.
Basel III: towards a more resilient banking system
As discussed earlier in the section 2.1 of this report, the new set of banking regulations, named Basel III was developed and published by the Basel Committee on Banking Supervision initially in December 2010 and then was reviewed in June 2011. This set of rules consists of two documents, namely:
Global regulatory framework for more resilient banks and banking systems;
International framework for liquidity risk measurement, standards and monitoring.
The need for this piece of regulations was caused by the financial and economic crisis of 2007-2008 and thus is saturated with lessons learnt from it. Implementation of Basel III is meant to enable banks absorb financial shocks of future crises and “prevent a competitive race to the bottom”26, which took place during the peak of the recent crisis. In addition, Basel III accords provide banking regulators around the world with an internationally harmonized framework for better monitoring of banks under their jurisdiction, especially those, which are considered to be systemically important banks (next: SIBs).
Original summary of regulations, which the Basel Committee on Banking Supervision proposed to achieve these objectives is given in Table 1 below.
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Table 1. Summary of regulations, proposed in Basel III Source: Original summary of Basel III reforms (2013)27
This set of capital adequacy and liquidity ratios are planned to come into strength during a transitional period of 2013-2019. Chart 3.429 illustrates the planned dynamics of minimum capital, which will be required from banks to hold, measured in percentage of risk-weighted-assets (next: RWA):
Chart 3.4. Dynamics of capital adequacy rules14%
The Liquidity Coverage Ratio, in its turn, being a ratio of highly liquid assets to total net liquidity outflow during 30 days of stress financing conditions, will be introduced in 2015 as 60 per cent with additional 10 per cent each subsequent year until the ratio reaches 100 per cent in 2019. The Net Stable Funding Ratio will be introduced only in 2018.
Expected impact on commercial banks: benefits versus costs
Basel III, without doubt, combines regulatory framework in capital adequacy for banks to date (i.e. Basel I and Basel II) and further enriches this framework with products of the recent financial crisis experience (e.g. capital conservation buffer and countercyclical buffer). Additionally and for the first time, it introduces a unique platform for controlling and monitoring liquidity positions of banks (i.e. through LC and NSF ratios) and emphasizes the increased systemic risk, which SIBs pose to entire financial system, and thus advocates for stricter regulation of them. In this fashion, the new rules enable the commercial banks better “digest” different external shocks and eliminate these internally without spreading the effects to its counterparties, and in case of SIBs to financial system and further over to real economy. In doing so, the rules minimize the risk of the need for future bailouts of troubled banks, often on account of taxpayers.
For instance, Gambacorta in his analysis30 of relationship between capital and liquidity requirements and long-term national output on example of the US has determined that for the period of 1994-2008, there were “rather limited” negative impact of tighter regulations on the output. At the same time, he was, however, able to determine a more substantial negative effect on banks’ return on equity (next: ROE). As a result, he comes to a conclusion that should tighter capital and liquidity regulations bring to a reduced risk of bank runs, the benefits of these regulations are much higher than its costs.
This opinion is also supported by the Macroeconomic Assessment Group, which was jointly established by the Financial Stability Board and the Basel Committee on Banking Supervision. In its study31, the Group has come to a conclusion that given the implementation of the new capital and liquidity measures over a time horizon of 9 years, the overall cost will be equal to annual 0.04 percentage points of decreased gross domestic product (next: GDP). At the same time, the overall calculated benefit will amount to annual 2.5 percentage points of increased GDP - thus casting no doubt on the big net positive effect of Basel III implementation, which according to the Groups findings is annual GDP increase of 2.46 percentage points.
The expected net positive effect of the new regulations on the United Kingdom’s economy is also the result of a research, which was completed by Yan et. al.32.The researchers even go a step further than the BCBS, claiming their evidence proves that the overall macroeconomic benefits of implementation of the Basel III capital and liquidity requirements will be even bigger than those mentioned above by the Macroeconomic Assessment Group’s report. In fact, they propose to increase the capital ratio from 8 percentage points in the regulations up to 10 percentage points and claim this ratio would be optimal for UK banks and the economy in general. The researchers also indicate benefits for banks from holding more equity and also that banks should turn their attention to raising funds increasingly from customer deposits to ensure stability of operations.
1 “The U.S. financial services industry grew from 4.9% of GDP in 1980 to 7.9% of GDP in 2007. A sizeable portion of the growth can be explained by rising asset management fees, which in turn were driven by increases in the valuation of tradable assets, particularly equity. Another important factor was growth in fees associated with an expansion in household credit, particularly fees associated with residential mortgages.”
Greenwood R. and Scharfstein D., (2012). The Growth of Modern Finance. Research Paper. Pp. 1
2 Two proposals include: capital requirement directive (CDR) and capital requirement regulations (CRR).
Bundesbank (2013). Basel III. [ONLINE] Available at: http://www.bundesbank.de/Navigation/EN/Core_business_areas/Banking_supervision/Ba sel3/basel3.html. [Last Accessed 01.05.2013].
3 Sharp J., Peters J. & Howard K., (2002). The Management of a student research project. 3rd ed. Aldershot: Gower Publishing Company. Pp.13-16.
4 Oxford University Press (2013). Corporate. [ONLINE] Available at:
http://oxforddictionaries.com/definition/english/corporate?q=corporate. [Last Accessed 05.05.2013].
5 European Commission (2003). SMEs. [ONLINE] Available at: http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/sme- definition/index_en.htm. [Last Accessed 05.05.2013].
6 T. Beck, A. Demirgüg-Kunt and V. Maksimovic, (2008). Financing patterns around the world: Are small firms different? Journal of Financial Economics. 89 (3), Pp.467-487
7 D. Hillier, M. Grinblatt and Sh. Titman, (2012). 'Raising Capital: The Process and the Players'. In: Financial markets and corporate strategy. 2nd ed. Glasgow: McGraw-Hill Education. Pp.6.
8 For more on equity financing, please refer to:
D. Hillier, M. Grinblatt and Sh. Titman, (2012). 'Equity Financing'. In: Financial markets and corporate strategy. 2nd ed. Glasgow: McGraw-Hill Education. Pp.58-80.
9 It must be noted here that up until June 2012, London Interbank Offered Rate (LIBOR) and Euro Interbank Offered Rate (EURIBOR) were also considered to be benchmark rates. However, after the British Barclays bank has admitted that its employees manipulated LIBOR, its reputation as a benchmark has been shaken substantially ever since. It was followed by a number of additional probes by Financial Securities Authority (FSA) - the financial markets regulator in the UK, which revealed participation of other leading European banks such Swiss UBS and German Deutsche Bank in rate-fixing practices. Similar probes are in progress in the US, with preliminary focus on 7 large banks including HSBC, RBS and others.
10 D. Hillier, M. Grinblatt and Sh. Titman, (2012). 'Debt Financing'. In: Financial markets and corporate strategy. 2nd ed. Glasgow: McGraw-Hill Education. Pp.33.
11 With exception of zero-coupon bonds, where no period coupon payments are made. Instead, a bond contract is sold at a discount price (i.e. lower than its face value) to compensate for coupon payments.
12 Although it is not always the case. For example, the producer of high-end personal computers and gadgets Apple Inc. sold corporate bonds on 30.04.2013 with different maturities from 3 years up to 30 years for total amount of 17 billion USD to finance part of its upcoming dividend payments. The company chose to issue bonds to avoid paying huge repatriation tax, in case of paying dividends from its large cash reserves, mainly accumulated outside the US.
Ch. Mead and S. Gangar (2013). Apple Raises $17 Billion in Record Corporate Bond Sale. [ONLINE] Available at: http://www.bloomberg.com/news/2013-04-30/apple-plans-six-part- bond-sale-in-first-offering-since-1996-1-.html. [Last Accessed 05.05.2013].
13 D. Hillier, M. Grinblatt and Sh. Titman, (2012). 'Debt Financing'. In: Financial markets and corporate strategy. 2nd ed. Glasgow: McGraw-Hill Education. Pp.32.
14 LeaseEurope and KPMG (2012). European Leasing. [ONLINE] Available at: http://www.leaseurope.org/uploads/EuropeanLeasing_extract(secured)%20(3).pdf.
[Last Accessed 05.05.2013].
15 V. Cunat, (2007). Trade Credit: Suppliers as Debt Collectors and Insurance Providers. The Review of Financial Studies. 20 (2), Pp.491-527
16 Maximization of shareholders’ value through minimization of WACC is expressed in the Economic Value Added (EVA®) model, developed by Stern Stewart & Co. [EVA® = Net Operating Profit After Tax - WACC*Net Operating Assets.] Thus decreased WACC will result in increased EVA®, which is assumed to increase stockholder’s value.
Stern Stewart & Co. (2013). Economic Value Added. [ONLINE] Available at: http://www.sternstewart.com/?content=proprietary&p=eva. [Last Accessed 05.05.2013].
17 T. Beck, A. Demirgüg-Kunt and V. Maksimovic, (2008). Financing patterns around the world: Are small firms different? Journal of Financial Economics. 89 (3), Pp.467-487
18 D. Hillier, M. Grinblatt and Sh. Titman, (2012). 'Raising Capital: The Process and the Players'. In: Financial markets and corporate strategy. 2nd ed. Glasgow: McGraw-Hill Education. Pp.17 and 25.
19 R. L. Porta, F. Lopez-De-Silanes, A. Shleifer and R. W. Vishny, (1997). Legal Determinants of External Finance. The Journal of Finance. 52 (3), Pp. 1131-1150
20 For more on Islamic financing please see: Muhammad Ayub, (2007). Understanding Islamic Finance. 1st ed. Chichester: John Wiley & Sons Ltd.
21 D. Hillier, M. Grinblatt and Sh. Titman, (2012). 'Raising Capital: The Process and the Players'. In: Financial markets and corporate strategy. 2nd ed. Glasgow: McGraw-Hill Education. Pp.13
22 Th. Beck, A. Demirgüg-Kunt and R. Levine, (2009). Financial Institutions and Markets across Countries and over Time. The World Bank, Development Research Group. Policy Research Working Paper # 4943. Pp. 2 and 41-43
23 Macroeconomic Assessment Group, (2011). Report: Assessment of the macroeconomic impact of higher loss absorbency for global systemically important banks. Basel: Bank for International Settlements. Pp. 1-2
24 N. Yoshino and T. Hirano, (2011). Procyclicality of the Basel capital requirement ratio and its impact on banks. Asian Economic Papers. 10 (2), Pp.22-36. (referred to abstract).
25 B. Allen, K. Chan, A. Milne and S. Thomas, (2012). Basel III: Is the cure worse than the disease? International Review of Financial Analysis. 25, Pp.159-166. (referred to abstract).
26 Basel Committee on Banking Supervision, (2011). Basel III: A global regulatory framework for more resilient banks and banking systems. Basel: Bank for International Settlements. p. 8
27 Basel Committee on Banking Supervision (2013). Basel III. [ONLINE] Available at: http://www.bis.org/bcbs/basel3/b3summarytable.pdf. [Last Accessed 13.05.2013].
Supplemental Pillar 2 requirements.
28 It is noteworthy to mention that until Basel III, there has been no internationally consistent set of liquidity rules for banking sector. Thus, these accords, capitalizing on lessons from the recent financial crisis, represent the very first regulatory framework for this important field.
29 Basel Committee on Banking Supervision (2013). Basel III: phase-in arrangements. [ONLINE] Available at:
http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf. [Last Accessed
30 L. Gambacorta, (2011). Do Bank Capital and Liquidity Affect Real Economic Activity in the Long Run? A VECM Analysis for the US. Economic Notes. 40 (3), Pp.75-91 (referred to abstract)
31 Macroeconomic Assessment Group, (2011). Report: Assessment of the macroeconomic impact of higher loss absorbency for global systemically important banks. Basel: Bank for International Settlements. Pp. 1-2
32 M. Yan, M. Hall and P. Turner, (2012). A cost-benefit analysis of Basel III: Some evidence from the UK. International Review of Financial Analysis. 25 (-), Pp.73-82 (referred to abstract)