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Concept and structure of the bank’s own capital

Category: Concept of the Bank and the Banking System

Under the bank’s own funds should understand the various funds set up by the bank to ensure its financial stability, trade and economic activities as well as profits as a result of the current and previous years.

The structure of the bank’s equity base is heterogeneous in composition and quality vary throughout the year depending on several factors and in particular on the quality of the assets of its own profits, the bank’s policy to ensure the sustainability of its capital base.

Statutory fund (capital) creates the economic basis of existence and is a prerequisite for formation of the bank as a legal entity. Its value is governed by legislative acts of the central banks and, moreover, is subject to agreement of the European Economic Community (EEC), which in 1989 regulated its minimum value of $ 5 million ECU.

Reserve capital (fund) is created from net profit (after tax) in an amount not less than 15% of the paid amount of the share capital and is designed to absorb unexpected losses in the bank’s activities and ensure the stability of its functioning.

The second group of funds formed as a result of the distribution of net profits, remaining at the disposal of the bank (funds for special purposes), and also reflects the use of net profit for certain purposes.

The third group of funds, the combined name of «additional capital, consists of:

— Proceeds from the sale of shares of the first holder at a price above face value — «seigniorage.» These funds increase the initial capital of the bank and its stable part;

— Capital gains, formed by the revaluation of fixed assets. The presence and magnitude of this fund is a reflection of inflation in the country and, therefore, do not act the qualitative characteristic of its activities. In its economic essence and nature of use of this fund can be regarded as a provision for impairment of fixed assets (fixed assets);

— The value of donated property received. The volume of the fund shows a source of growth of tangible assets of the bank, and the rules of use (to cover possible losses) can take it to a group of reserve funds.

The fourth group of funds established to cover the risks of certain banking operations and thus achieve the stability of banks by absorbing the losses due to the accumulated reserves. These include: provisions for losses on loans, securities and other assets. The value of these reserves suggests, on the one hand, the qualitative structure of bank assets, and on the other — on the margin of safety of the bank, especially with regard to reserve funds created from net profit (for example, reserves for possible losses on loans first group).

The funds the second, part the third and fourth groups according to their intended purpose are very mobile, as they are used for current expenses or capital investment bank associated with the development of its own facilities (eg, payment of premiums, benefits, equipment, costs, ongoing in excess of the limits, classification of them on the operating costs, the provision of charity care, etc.), ie the use of these funds due to the decrease of the bank property.

Therefore, the funds of such funds or their equivalent can not be left in the bank and use them for other purposes, ie act as a bank’s capital.

Thus, the theory of banking distinguishes the concept of equity and equity of the bank. The concept of «own funds» — the most common include all liabilities, formed during the bank’s activities: the charter, reserve and other funds of the bank, all the reserves by the bank, and retained earnings from previous years and current year. Bank’s own capital — a value determined by calculation. It includes the articles of their own funds (and even borrowed funds), which on the economic meaning can serve as the bank’s capital. The main elements of its own funds, ie underlying funds established in accordance with the law, and reserves established by domestic sources in order to maintain the bank’s activities are included in the bank’s capital if they meet the following principles:

— Stability;

— Subordination to the rights of creditors;

— The absence of fixed charges of income.

Under the bank’s own capital should be understood specially created funds and reserves that are intended to ensure its economic stability, absorption and possible losses are to use the bank for the entire period of its operation. The bank’s capital includes statutory, reserve capital, other funds that do not have the period of use, promoter’s profit (the result of the emission), undistributed profits of the current and previous years, left at the disposal of the bank and confirmed by the auditors, the reserves to cover various risks and performs a number of important functions in the activity Bank.

Functions performed by the bank capital, ambiguously defined as a domestic and Western literature. There are three main functions: protective, operational and regulatory. Since a large proportion of bank assets financed by investors, the main function of a very limited amount of equity capital is protecting the interests of depositors. In addition, the capital of the bank reduces the risk of the bank’s shareholders. Protective function means that you can compensate depositors in the event of liquidation of the bank, as well as the preservation of solvency by creating a pool of assets, allowing the bank to work despite the threat of damages. In this case, however, it is assumed that most of the loss is covered by the expense of capital and current income of the bank. Unlike most companies preserve the solvency of the commercial bank to cover only part of equity. Typically, the bank is solvent, remains intact equity, ie while the value of assets is not less total liabilities (net of unsecured) issued by the bank and its shareholders’ equity.

Capital plays the role of a protective «cushion» and allows the bank to continue operations in case of large unexpected losses or expenses. To finance these expenditures, there are various reserve funds are included in shareholders’ equity, and for mass non-payment customers on loans to cover losses, you may want to use a portion of equity.

Operational function of bank capital is of secondary importance compared to the defensive. It includes the allocation of own funds to purchase land, buildings, equipment, and the establishment of a financial reserve for unexpected losses. This source of funding is indispensable in the initial stages of the bank, when the founders engaged in a number of priority spending. At subsequent stages of development bank role of equity capital is not less important part of the funds invested in long-term assets, the establishment of various reserves. Although the main source of financing for the expansion of operations is the accumulated profit, the banks often resort to new issues of shares or long-term loans for events of a structural nature — the opening of branches, merges.

Implementation of the regulatory function of capital is linked to the special public interest in the successful functioning of banks. With the index the bank’s capital by public authorities assess and monitor the activities of banks. Typically, rules relating to equity of the bank, include requirements to its minimum size restrictions on assets and conditions of purchase of assets of another bank. Prudential standards set by the central bank, mainly based on the size of the bank’s own capital. In terms of the classification of the functions attributed to the regulatory function and use the capital to curb lending and investment operations (to the extent that bank loans and investments are limited to available equity).

Other sources, recognizing that the primary purpose of bank capital is to reduce risk, emphasize the following features:

— Capital serves as a buffer to absorb losses and preserve solvency;

— Provides access to capital markets, financial resources and protect banks from liquidity problems;

— Inhibits the growth of capital and reduces risks.

All these features help to reduce capital risk. Such an approach is more practical and suited for management purposes, a commercial bank.

The role of capital as a buffer against loan losses evident when considered in the context of cash flow. If bank customers fail to fulfill their obligations under the loan, instantly reduced cash flow from interest and principal payments. Outflow does not change. Bank remains solvent, while the amount of inflow exceeds the outflow. Here, capital serves as a buffer, because it reduces the induced outflows.

The Bank may postpone the dividend but shares not being able to pay. Interest payments on bank debt, by contrast, are mandatory. Banks with sufficient capital release new bonds or shares to replace the lost cash inflows of new and buy time until they solved the problem with the assets. Thus, the higher bank capital, the more assets may be unpaid, before the bank becomes insolvent, and the less the risk of the bank.

Adequate bank capital reduces the operational problems by providing free access to financial markets. Capital gives the bank to make loans from traditional sources at normal rates. Large shareholders ‘equity provides a stable reputation of the bank depositors’ confidence in him.

Capital inhibits growth and reduces the risk of restriction of new assets that the bank can purchase through financing with debt. This function is closely related to the norm established by the state authorities of capital to assets. So, if banks decide to increase the size of loans or buy other assets, they should support growth through additional equity financing. This prevents speculative asset growth, as banks must always remain within its capacity a successful asset management.

These functions of bank capital show that equity — the basis of commercial bank activities. It ensures its independence and ensure its financial sustainability as a source to offset the negative impact of various risks, which are borne by the bank.

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