The Banking Sector in Ghana: Issues in relation to Current Reforms

TABLE OF CONTENT

Acknowledgement

Abstract

List of Tables and Figures

Abbreviation

Table of Content

Chapter One
Introduction
1.0 Introduction
1.1 Background of the Study
1.2 Statement of the Problem
1.3 Objective of the Study
1.4 Research Questions
1.5 Research Methodology
1.6 Significance of the Study
1.7 Scope and Limitation of the Study
1.8 Chapter Disposition

Chapter two
Literature review
2.0 Introduction
2.1 Meaning of Capitalization
2.2 The Types of Capitalization
2.3 Addressing Recapitalization Challenges Confronting Ghanaian Banks
2.4 The Need for Capitalizing Banks
2.5 A Sketch of the Reasons for and against Recapitalization
2.6 Essentials for a Successful Recapitalization
2.7 A Strategic approach to Cost Reduction in Banking
2.8 Recapitalizing through the Stock Market
2.9 Effects of Sound Bank Capital on Bank Behaviour
2.10 Foundations for the Link between Relationships, Illiquidity and Bank Capital
2.11 Disciplines from the Threat of Closure due to Capital Requirement
2.12 Challenges of Recapitalization
2.13 Prospects of Recapitalization
2.14 Summary and Conclusion

Chapter three
Research methodology
3.0 Introduction
3.1 Research Design
3.2 Study Population
3.3 Sampling Techniques
3.4 Research Instrument
3.5 Data Collection
3.6 Pretesting
3.7 Data Processing and Analysis
3.8 Ethical Consideration

Chapter four
PRESENTATION AND ANALYSIS OF DATA
4.0 Introductions
4.1 Analysis of Demographic Features of Respondents
4.2 Issues Relating To Challenges of Mobility of Extra Cash for Recapitalization
4.3 Analysis of Issues Relating to the Attraction of Strategic Investors
4.4 Analysis of Issues Relating to Generating more Funds from Ghana Stock Exchange
4.5 Analysis of Issues Relating to Reducing Cost to enhance Recapitalization Process
4.6 Findings

Chapter FIVE
SUMMARY, CONCLUSION AND RECOMMENDATION
5.0 Introduction
5.1 Summary
5.2 Conclusion
5.3 Recommendation

References

Appendix I: Questionnaires
Appendix II: Calculation of Operating Capital

Chapter One

1.0 Introduction

The study examines the challenges confronting commercial banks in Ghana as they strive to honour the recapitalization directive issued by the industry’s regulator, that is, Central bank of Ghana. It begins by outlining the background to the study, followed by the statement of the problem, rationale and objective of the study prior to presenting the research questions. The research methodologies, significance of the study, as well as the chapter organization have all been featured in this opening chapter.

1.1 Background of the Study

Banking reforms have been an ongoing phenomenon around the world right from the 1980s; it has however more intensified in recent years due the impact of globalisation which is precipitated by continuous integration of the world market and economies. Financial restructuring mainly involve the recapitalization of the banks with equity injection where liquidity was low, and the cleaning up of the balance sheets of non-performing assets.

Capitalization refers to the process of determining the quantum of funds that a firm needs to run its business. Various financial management experts have indicated varying degrees of definition for capitalization. According to Guthman and Dougall (2002) “capitalization is the sum of stocks and bonds outstanding”. Bonneville and Dewey (2002) also note that

“capitalization is the balance sheet value of stocks and bonds outstands”. Dewing (2004) is of the view that “capitalization is the sum total of the par value of all shares”.

Capitalization is an important component of reforms in the banking industry, owing to the fact that a bank with a strong capital base has the ability to absolve losses arising from non performing liabilities. Attaining capitalization requirements may be achieved through consolidation of existing banks or raising additional funds through the capital market Banking sector reforms and recapitalization have resulted from deliberate policy response to correct perceived or impending banking sector crisis and subsequent failures. This crisis can be triggered by weakness in banking system characterized by persistent illiquidity, insolvency, undercapitalization, high level of non-performing loans and weak corporate governance, among others.

The global financial and economic crisis presents significant challenges for many African countries including Ghana. It has also exposed weaknesses in the functioning of the global economy and led to calls for the reform of the international financial architecture. Although the crisis was triggered by events in the United States housing market, it has spread to all regions of the world with dire consequences for global trade, investment and growth. The crisis presents a serious setback for Africa because it is happening at a time when the region is making progress in economic performance and management.

Recapitalization in Ghana comes with every amendment to the existing banking laws. Indigenous and foreign commercial banks in Ghana have therefore been instructed to augment their capital level to a minimum of GH¢60 million by December of 2012. The indigenous banks according to the Bank of Ghana (BOG) have been given a longer period to meet the deadline, this is having been given GH¢25 million by 2010 and GH¢60 million by December 2012.

According to Acquah (2006), it was necessary for the banks to recapitalize in order to support the economi growth of the country. The financial sector continues to grow and thus there is the need to have a strong capital base in order to compete with colleagues on the African continent and also to withstand unforeseen external shocks like the recent financial crisis which can throw the economy off gear. This measure has the strategic objective of improving liquidity levels within the banking industry. It is believed that vital sectors of the economy continue to register serious financing challenges.

Globally commercial banks have not taken re-capitalization orders from their Central Banks kindly at all. The president of German Deutsche bank was quoted as threatening to resist any pressure to recapitalize because “it would be impossible for many banks to raise capital from the markets in current climate” and that they would “do everything to avoid a forced recapitalization”.

Asedionlen (2004) also questioned the long term impact of recapitalization and came up with his hypothesis that “recapitalization may raise liquidity in short term but will not guarantee a conducive macro-economic environment required to ensure high asset quality and good profitability”. Locally a good number of Ghanaian banks are sensing their limitation in meeting the new capital level of GH¢60 million by the close of 2012. Some merger propositions tabled a little over a year ago by some of the ‘weak’ banks are yet to be taken into consideration by their shareholders.

Perhaps it might be worth noting that the origin, determinant, trends, importance and implication of bank recapitalization has been scantly discussed in literature and therefore this study to assess the prospects and challenges of re-capitalizing commercial banks in Ghana could in a small way, contribute towards enhancing the general body of knowledge on the subject.

1.2 Statement of the Problem

According to Soyinbo and Adekanye (2002) and Adam (2003) nearly 100 out of the 128 banks in Nigeria failed and collapsed as result of inadequate capital base, mismanagement of funds, overtrading, and lack of sound regulation, control and unfair competition from the foreign banks. Being conscious of the afore-mentioned challenges which disrupted the Nigerian financial services environment and moreover given the fact that some of these Nigerian banks are also players in the Ghanaian industry the Central Bank of Ghana quickly devised a strategy not only to shore up the liquidity levels of the banks but also strengthen its banking supervisory department through extensive training and development activities for it personnel.

Unfortunately, an analysis of financial statements published by the local Ghanaian dailies at the close of March 2011 showed unequivocally that as at December 2010 only 6 out of the 26 players in the industry had crossed the envisaged 2012 new capital requirement of GH¢25 million. As at November, 2011, the governor of the Central Bank of Ghana, Kwesi AmissahArthur lamented over the fact that out of the twelve(12) wholly owned Ghanaian commercial banks only five (5) have been able to meet the new capital adequacy requirements of GH¢60million. He warned that banks which are unable to meet the new capital quantum by the close of December, 2012 “will have their universal licenses revoked and converted into non-banking institutions”. He advised management of ‘struggling’ banks to consider going to the stock exchange or move towards acquisitions and mergers.

How are Ghanaian banks strategizing to improve upon their cash mobilization efforts? Is the Ghana Stock Exchange (GSE) sophisticated enough to help raise the needed new capital for the banks? Do the existing banks have the required capacity and capabilities to attract international strategic investors? Can Ghanaian banks cut cost to enhance loanable fund thereby improving upon their liquidity levels? These and other problems form the thrust of this study.

1.3 Objective of the Study

The study has the objective of:

1. Examining the adequacy of the cash mobilization strategies of the banks.
2. Assessing the prospects of generating more funds from the Ghana Stock Exchange.
3. Investigating the possibility of International partners such as International Financial Corporation (IFC) increasing its investment in local banks like Merchant Bank Ghana Limited (MBG), etc.
4. Exploring avenues where operating cost can be reduced to enhance available funds for lending purposes.
5. Examining any restriction placed on the banks in mobilizing cash.

1.4 Research Questions

- What challenges confront the Ghanaian banks in their cash mobilization efforts towards meeting the new minimum capital requirement?
- How can the banks generate more funds from the Ghana Stock Exchange and other Stock Exchanges outside the country?
- What are the modalities for sourcing funds from international strategic investors and International Finance Corporation?
- How can the bank reduce operating cost to save the money for more lending purposes?
- What are some of the restrictions that the Central Bank places on banks to rope in more funds?

1.5 Research Methodology

This segment of the introductory chapter has been dichotomized into:

- Sources of data
- Data Collection and analysis

1.5.1 Sources of Data

Both primary data and secondary data will be employed in the study. Primary data will emanate from the firsthand information on the current state of the banks and the measures being putting in place to meet the deadline. This will be obtained from interacting with management members and officials of the six banks within the Accra business district. These banks include Prudential Bank Limited (PBL), National Investment Bank (NIB), Ecobank Ghana Limited, Ghana Commercial Bank (GCB), Merchant Bank Ghana (MBG) and Zenith Bank.

Secondary data will be derived from analyzing reports especially financial statements of commercial banks, articles from journal and contemporary publications on challenges and prospects of recapitalization of commercial banks.

1.5.2 Data Collection and Analysis

The questionnaire technique will be adopted as research instrument and research questions will endeavour to evaluate strategies by the banks to shore up capital level. Specifically the interaction with management members and bank officials will cover issues such as what efforts the banks are making to meet the new minimum capital levels? With recent ‘swallowing ups’ of some of the banks, it has come to light that certain banks are suffering from liquidity issues (Ghana Banking Survey, 2011), so the question is, what can be done internally by way of reducing cost to improve liquidity by way of reducing cost? What is the liquidity position of these banks? What restrictions are placed on banks by the Central Bank in the mobilization of more funds? What efforts are being made to secure strategic international investors? What role could the Ghana Stock Exchange play in addressing the challenges faced by banks to meet the new liquidity levels? The researcher believes that answers to these questions would help achieve the objectives of the study.

Purposive or non-probability sampling technique will help to directly approach management members of the various banks for their views on the subject of capitalizing banks. A time frame not exceeding two weeks will be agreed upon within which each respondent will be expected to complete answering the questionnaire. At the agreed time, the researcher will personally visit all the respondents to retrieve the answered questionnaires. Statistical Package for Social Science (SPSS) was used to analyze the data and the resulting pie charts, bar graphs, graphs, frequency tables, and others, were featured in the fourth chapter. Moreover, the accounting package TOPAZ aided in the computation and graphing of the relevant accounting ratios which helped in assessing the current financial situation of the various banks.

1.6 Significance of the Study

The study is important in that:

- The findings will contribute to the general body of knowledge concerning recapitalization of banks
- It will prompt the management of universal bank on how to generate more funds to operate
- Other financial institution which might be privy to the findings would compare notes and act appropriately.
- The researcher’s knowledge on subject of the study will be deepened.
- Other students of Methodist University College Ghana (MUCG) graduate school who might be researching along similar lines will use the final report as a useful reference material.

1.7 Scope and Limitations of the Study

1.7.1 Scope

The Accra Business District will constitute the study area within which bank officials and management members of the six leading banks will be interviewed. The distribution of the respondents will be as follow:

illustration not visible in this excerpt

1.7.2 Limitations of the study

Currently Ghana has 26 fully fledged universal banks with a little over 700 branches

nationwide. Using only the headquarters of six (6) banks places a limitation on the adequacy of information for the study. Moreover socio-economic conditions in places outside the capital city of Accra are much different from what pertains in Accra alone and this creates a credibility gap when generalizing the findings of the study. Although a much wider scale of the study could have enhanced the outlook of the study, the researcher does not have the logistics especially funds and time for such an extensive venture. Notwithstanding the aforementioned constraints the researcher is poised to turn out a final report that will be representative of the banks sampled and selected.

1.8 Chapter Disposition

The study will be captured under five chapters. Chapter One will introduce the study by outlining the background information, statement of the problem, objectives of the study, justification of the study, research methodology, scope and limitation of the study.

Chapter Two will review contemporary literature on capitalizing banks and related matters. Essentially it will discuss various types of capitalization of commercial banks, the merit and 9 demerits, causes of under and over-capitalization, the history and practices of capitalization of commercials banks within Ghana’s financial services environment, ways of improving capitalization of commercial banks in Ghana and many more.

Chapter Three will outline the details of the research methodology. It will feature the research design, the sources of data, sampling techniques, research instruments, data collection strategies and data analysis techniques.

Chapter Four will present the analyzed data and discusses the findings.

Chapter Five is the summarization of the study, appropriate recommendations and useful conclusions drawn.

Chapter Two

Literature Review

2.0 Introduction

This chapter reviews contemporary articles and publications on challenges of recapitalizing commercial banks. It begins with definitions of terms relating to capitalizing of banks prior to discussing literature on the needs to recapitalize banks. It further examines essentials for successful recapitalization, a strategic approach to cost reduction within the financial services environment as well as recapitalizing through the stock exchange. The review also covers the effect of sound bank capital and bank behaviour as well as the challenges of recapitalization.

2.1 Meaning of Capitalization

Reputable banking and finance writers such as Flannery (2005), Hofmann (2009) and Kashyap et al (2008) all refer to capitalization as the process of determining the quantum of funds that a firm needs to run its business. Ammann (2001) also notes that capitalization is only the par value of share capital and debenture and it does not include reserve and surplus. According to Cooper et al (2003) “capitalization is the sum of the par value of stocks and bonds outstanding”. To Danielson et al (2004) “capitalization is the balance sheet value of stocks and bonds outstands”.

2.2 The Kinds of Capitalization

In the view of Cooper et al (2003) capitalization may be classified into the three important types based on its nature, namely; over capitalization, under capitalization and water capitalization.

2.2.1 Over Capitalization

Over capitalization, Hassan and Bashir (2009) indicate, refer to the company which possesses an excess of capital in relation to its activity level and requirements. Simply, over capitalization is having more capital than is actually required and the funds are not properly utilizing the funds. According to Ito and Sasaki (1998) a business concern is said to be overcapitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued.

A business is said to be over capitalized when the total of owned and borrowed capital exceeds its fixed and current assets, that is, when it shows accumulated losses on the assets side of the balance sheet. An over capitalized company can be likened to a very fat person who cannot carry his weight properly. Such a person is prone to many diseases and is certainly not likely to be sufficiently active. Tanner (1995) argues that unless the condition of overcapitalization is corrected, the company may find itself in great difficulties.

Causes of Over Capitalization

According to Nakaso (1999) over capitalization occurs due to the following causes: over issue of capital by the company, borrowing large amount of capital at a higher rate of interest, providing inadequate depreciation to the fixed assets, excessive payment for acquisition of goodwill, high rate of taxation and under estimation of capitalization rate.

Effects of Over Capitalization

Diamond (2001) also states that over capitalization leads to the following effects; reduce the rate of earning capacity of the shares, difficulties in obtaining necessary capital to the business concern, leads to fall in the market price of the shares, creates problems on reorganization and leads to under or mis-utilisation of available resources.

Remedies for Over Capitalization

According to Bikker and Hu (2002) over capitalization can be reduced with the help of effective management and systematic design of the capital structure. Efficient management can reduce over capitalization, redemption of preference share capital which consists of high rate of dividend, reorganization of equity share capital and reduction of debt capital.

2.2.2 Under Capitalization

Under capitalization is the opposite concept of over capitalization and according to Banks (2004) it will occur when the company’s “actual capitalization is lower than the capitalization as warranted by it earning capacity”. Under capitalization is not the so called inadequate capital. Under capitalization has been described by Hogath and Thomas (1999) as, “a corporation may be undercapitalized when the rate of profit is exceptionally high in the same industry”. Diamond (2001) defined under capitalization as “an excess of true assets value over the aggregate of stocks and bonds outstanding”. When owned capital of the business is much less than the total borrowed capital than it is a sign of under capitalization. This means that the owned capital of the company is disproportionate to the scale of its operation and the business is dependent upon borrowed money and trade creditors.

Under-capitalization according to Shin (2006) may be the result of over-trading. It must be distinguished from high gearing. In case of capital gearing, Rochet (2008) explains that there is a comparison between equity capital and fixed interest bearing capital (which includes reference share capital also and excludes trade creditors) whereas in the case of under capitalization, comparison is made between total owned capital (both equity and preference share capital) and total borrowed capital (which includes trade creditors also). Under

capitalization is indicated by Low proprietary Ratio, Current Ratio and High Return on Equity Capital.

According to Ben-Nacour and Goaied (2008) the effects of under capitalization may be payment of excessive interest on borrowed capital, use of old and out of date equipment because of inability to purchase new plant and high cost of production because of the use of old machinery. It is the conviction of Acquah (2006) that when Ghanaian banks are recapitalized, players in the industry will modernize their services delivery systems, open more branches and extend more loans to the Small and Medium Scale Enterprises (SME) sector thereby playing their proper role in the socio-economic development in the country.

Causes of Under Capitalization

According to Berger (1995) under capitalization arises due to the following causes; under estimation of capital requirements, under estimation of initial and future earnings, maintaining high standards of efficiency, conservative dividend policy, desire for control and trading on equity.

Effects of Under Capitalization

Under Capitalization in the view of Tanner (1995) leads to certain effects on the company and its shareholders. It leads to manipulation of the market value of shares, increases the marketability of the shares, more government control and higher taxation, feelings of exploitation by consumers of the company and high competition.

Remedies for Under Capitalization

In the opinion of Ammann (2001) Under capitalization may be corrected by taking these remedial measures: compensating with the help of fresh issue of shares, increasing the par value of share may correcting by the issue of bonus shares to the existing shareholders and reducing the dividend per share by way of splitting up of shares.

2.2.3 Watered Capitalization

If the stock or capital of the company is not backed by assets of equivalent value, Hogarth and Thomas (1999) describe it as watered stock. In other words, watered capital means that the realizable value of assets of the company is less than its book value. According to Hogarth and Thomas (1999), “a stock is said to be watered when its true value is less than its book value”.

2.3 Addressing Recapitalization Challenges Confronting Ghanaian Banks

Officials of the Central Bank of Ghana have been deliberating on the constraints wholly Ghanaian owned banks encounter in meeting Bank of Ghana’s (BOG) minimum capital requirement of GH¢60 million. According to governor Amissah-Arthur (2012) as at the close of December 2011 only 16 out of the 27 players in the banking industry of Ghana had been able to meet the recapitalization directive.

Out of the 16 ‘successful’ banks 13 (81.25%) are foreign banks meaning that majority of the purely indigenous banks are yet to find their feet as far as the new capital requirement is concerned. Meanwhile the Central Bank’s Monetary Policy Committee (MPC) at its last quarterly meeting for the 2011 warned that “the central bank would not give reprieve to any bank that failed to shore up its capital to GH¢60 million” within the stipulated time. The MPC added that “recalcitrant banks would see their Licenses being revoked while they would be converted to non-bank financial institutions”

The Central Bank (2012) advises struggling local banks to “invite more shareholders by listing on the Ghana stock Exchange (GSE)”. Initially the Bank of Ghana expect local banks to list just enough shares to raise fund necessary to close the capital gap, subject to meeting the GSE’s minimum floatation threshold of 25 percent of the banks equity. Local banks should consider mergers and acquisitions in the banking industry (2012), “there is the need for such moves in order for the banks to undertake big ticket deals.” Governor Amissah- Arthur (2012) expressed serious reservation over the fact that “Ghanaian banks had not done well in the area of syndication which is the best way to go when there are huge projects to be underwritten”.

On the issue of mergers and acquisition, Ecobank Ghana is said to have concluded negotiation to acquire the The Trust Bank (TTB) while BPI bank has also lost its identity to UT bank. CAL bank, First Atlantic Merchant Bank, have all not ruled out the possibility of mergers. The recapitalization directive from the Central Bank itself has been received with mixed feelings within the financial circles in Ghana. Opponents to the directive argue that banks should be allowed to operate according to their strength and that it is unfair forcing every bank to operate above GH¢60 million.

Entuah (2012) argues that in a competitive environment, some players will obviously have more capital than others because they have a bigger sphere of operation and therefore will be looked upon as industry leaders. The source further lamented over the fact that most banks are being forced to seek international strategic partners who invariably will own more shares in these banks and therefore could change their operational orientation to the detriment of the socio-economic development of the country. It further discloses that some bank have no immediate plan to use such huge funds and therefore might not optimize the time value of their loose funds. The Central Bank however maintains that the new order will assist purely local banks to rub shoulders with the foreign banks in syndicated businesses which bring in more income.

2.4 The Need for Capitalizing Banks

According to Field (2008) “when a nation’s bank experience major losses, depositors, the markets, and regulators respond” The market responds by making it difficult for the bank to raise funds. Depositors may rush to withdraw funds from the banks. The regulators, according to Levine (1998) respond by closing banks, guaranteeing their liabilities, or recapitalizing them. The most obvious decision that regulators have to make is whether to let banks fail. Do their inabilities to raise sufficient private capital indicate that they are not viable or produce future services that are worth less than their cost, and thus should be closed? Only if the government, depositors, and borrowers were first allowed to jointly renegotiate first, would the inability to restructure indicate that the banks are not viable.

According to Hogarth and Thomas (1999) in many countries, there is a very deep government safety net and substantial regulations that influences discussions on bank capital structure. So one approach in the view of Sufian and Chong (2008) would be to ignore the markets and analyze bank recapitalization as a bargaining situation between banks and regulators. Even with total deposit insurance, Hassan and Bashir (2003) are of the opinion that the banks will need to consider the effects of their credit rating on the other lines of business they can provide. If the level of capital is below the minimum necessary to stay in business (and this minimum will actually be enforced), then, Flannery (2009) thinks banks will need to do whatever it takes to increase their capital to the minimum.

This “whatever it takes” type of bank behavior, Nakaso (1999) argues could have undesired effects on the economy. It focuses on the effect of bank recapitalization on banks and their existing borrowers. According to Banks (2004) the effect on future borrowers (new business development) is ignored on the basis that new banks, other recapitalized banks, or even foreign banks could provide such new relationship-based funding without a subsidized recapitalization of the majority of existing banks. Recapitalizing a large number of banks, according to Goddrad et al (2004), is desirable only if it protects the value of existing relationship lending and human capital in banks and firms. If the reason to have a wellcapitalized banking system is to ensure that new relationships can be established, then it can be achieved by recapitalizing a few of the best banks.

The analysis here points out that the recapitalization, and its extent, can result in transfers between banks and borrowing firms that can go in either direction. This result is because according to Rivard and Thomas (1997) bank capital influences the bargaining between a bank and its borrowers. In addition, recapitalization can have efficiency effects by influencing a bank’s decision whether to foreclose on its defaulted loans. According to Cooper et al (2003) the amount of current bank capital, affects the behavior of a bank when it is required to have a minimum amount of capital in order to remain in business. The same effect occurs when the threat of closure due to low capital comes from market participants who, according to Brissimis et al (2008) may not provide capital or from potentially uninsured depositors who may withdraw deposits.

2.5 A Sketch of the Reasons for and Against Recapitalization

The effect of bank capital on bank behavior and borrower welfare, in the views of Neely and Wheelock (1997) depends on some characteristics of the borrower and of the bank. The relevant characteristic of the bank is the presence or absence of relationship lending. Relationship lending implies that the lender has a special skill in evaluating a borrower or in committing to providing a long-term financing policy that a new lender cannot provide. One expects that relationship lending is most important for loans to firms rather than to consumers and when the anticipated response to a potential default, according to Shin (2006) is renegotiation rather than immediate foreclosure of collateral.

Shin (2006) again defines a relationship lender as one whose knowledge allows it to induce the borrower to make larger future payments. As a result, a relationship lender can lend more today than other lenders and is less inclined to foreclose on a loan because it can collect more in the future. However, if the relationship lender is in financial trouble, it may be unable to provide these larger loans or loan extensions. The relationship lender’s special loan collection skill, Rochet (2008) makes loans illiquid and hard to sell or borrow against. If there is no relationship lending, then a bank’s financial situation has no effect on the borrower. Another lender can replace an undercapitalized bank, and the undercapitalized bank can either sell the loan or accept a payment that the borrower raises from borrowing elsewhere. Only when relationship lending is important, according to Aoki et al (1994), is the financial health of particular bank lenders of critical importance to their borrowers and to the economy as a whole.

According to Hogarth and Thomas (1999), the characteristics of a bank’s borrowers also partly determine the effect and desirability for providing subsidized capital to a distressed bank. The relevant borrower characteristic is the viability of its business. A business, Komidu (2008) thinks, is viable if it can commit to paying the relationship lender more (in present value) than the lender can rise by foreclosing today. A viable borrower should not lose access to credit, and it will not lose its access to credit from its bank if the bank is well capitalized. A nonviable borrower should lose access to credit, and in many cases a bank will cut off credit to such a borrower independent of its capital position. Berger (1995) argues that the only case where a subsidized recapitalization may be justified is when the undercapitalized bank is one with lending relationships and viable borrowers. In all other cases, recapitalization is a government subsidy without social value.

2.6 Essentials for a Successful Recapitalization

According to Cooper et al (2003) investors will invest in a distressed bank if they believe the institution has a solid core franchise. That is, despite the problems in the credit or investment securities portfolio, the bank has to have a track record of generating sustainable operating income, have a solid core customer base and serve an attractive marketplace. Size of the institution also matters in determining whether it is a valuable core franchise or not. In the view of Field (2008) many investors will be attracted to distressed banks in or near large metropolitan areas, believing they provide the best opportunities for growth and expansion and investor returns.

But a solid bank franchise in a smaller metropolitan area may have unique favourable characteristics if investors can be persuaded that the bank can be used as a “base” for acquisitive growth into larger metropolitan markets or if the bank has a niche business, such as agricultural lending, mortgage banking or specialty finance. The next question is whether, after making realistic assumptions based on the third party credit review, the bank has any positive equity capital remaining. This so-called “burn down” analysis is more complicated than simply starting with the holding company’s tangible equity capital and subtracting the losses predicted from a fairly rapid disposition of Non-Performing Assets (NPAs) because tax effects need to be considered, including the deferred tax asset, as well as disposition and carrying costs of the NPAs.

The burn down analysis according to Flannery (2009) needs to be realistic, indeed conservative. The equity capital that is left after the burn down analysis is the capital left for the current stockholders and in many cases this analysis proves that the current stockholders will need to suffer severe dilution in order for a new investor to agree to invest fresh capital in the institution. In the view of Shin (2006) new investors will not finance old credit quality problems of the bank. In order for the burn down analysis to have credibility, the third party credit assessment needs to be completed well before the burn down analysis is run. Bank leadership and management post-recapitalization will be another key element to consider.

In the opinion of Banks (2004) institutional investors will want to know who will be running the institution going forward, their track record, and their vision for deploying the new capital and translating it into reasonable investor returns. Normally, new investors will not have confidence in the Chief Executive Officer (CEO) that managed the bank into its current position of distress. Therefore, the board will have to make a serious decision as to whether to replace the CEO prior to launching a recapitalization or acknowledging that once a lead investor is identified that a process needs to be put into place to identify and hire a new CEO.

While the CEO may need to go in order to get the recapitalization done, the fate of other members of senior management is not nearly as certain. Other members of senior management may be asked to stay on temporarily or permanently to promote a smooth transition during the recapitalization, though the new CEO may have his own management team to bring forward. One can imagine the serious discussions in the boardroom about replacing the CEO as part of a successful recapitalization. But a recapitalization would not be on the table unless the bank was under severe distress and needed a significant amount of capital to survive. Because corporate survival is on the line and after the wall of denial is conquered, boards will typically make the changes that need to be made to avoid receivership.

2.6.1 Creating Stability during Transition

From the start of the turnaround program through a recapitalization, stabilizing the franchise needs to be a priority. While stability in many areas is important, no issue is more important than liquidity. Ammann (2001) argues that a bank can continue to function as a going concern even if its capital is all but totally depleted. But if the bank loses access to liquidity sources, it cannot fund its day-to-day operations. Moreover, we have seen countless examples where the regulators have intervened quickly to put a bank into receivership following a one- or two-day liquidity run or simply an unusually high degree of liquidity stress that threatens the bank’s ability to fund deposit withdrawals. Thus, management and the turnaround leader need to establish liquidity reports and a process for addressing liquidity needs over the six- to nine-month time period that a turnaround and recapitalization plan can take to execute.

According to Froot (2001) capital adequacy is one important area that requires focus and stabilization techniques, though this is much harder to control than liquidity, because swings in capital can be large and dramatic based on credit quality, and capital impairment can occur based on judgment calls rather than counter-party actions. In any event, as a turnaround program is initiated, the turnaround leader will put in place a monitoring and reporting process that measures the bank’s capital against the projections on a monthly basis. Stress to capital will be a topic of frequent conversation and once the bank drops to the significant undercapitalized level, the bank regulators will increase their rhetoric and monitoring of capital as well.

This is why it is important early in the turnaround to find as many constructive approaches as possible to enhancing the bank’s capital ratios through balance sheet shrinkage or finding capital accretive opportunities, such as selling securities with a gain or reversing compensation accruals if possible. Every percentage of extra capital in relation to the projected capital thresholds matters as the bank incurs more capital depreciation resulting from credit losses and when buying time is essential to executing on a recapitalization plan.

In the view of Nakaso (1999) keeping employee morale up when the bank faces an uncertain future and rumors are percolating about its survival prospects is a daunting task. It is important that senior management maintain credibility with employees but of equal importance is that they use employees as the first line of defense against deposit runs and customer concerns about the safety of their deposits. There is no magic formula to keeping employees right minded but the turnaround leader must have as a goal keeping employees engaged and hopeful that the bank will survive and that a recapitalization transaction is well planned for and quite possible. Of course soured employee morale can lead to key employee departures, including of members of senior management who are best versed in the troubles that beset the company and its future prospects.

Creating as much stability in the employee base as is reasonably possible as a key strategy and a tactical plan to accomplish this goal is essential early on in the turnaround planning.

Stockholders will get wind of the bank’s stressed financial situation either through communication from the bank or the holding company management or as a result of the publication of a regulatory enforcement action against the bank. According to Berger (1995) early thought needs to be given to a communication plan toward stockholders and a strategy that keeps stockholders fully and honestly informed, at the appropriate time, about key developments affecting their investment.

Disgruntled, complaining or litigious stockholders in the view of Hogarth and Thomas (1999) can distract management and the board from the primary task — saving the company. Indeed litigious stockholders can take steps that interrupt or delay key corporate actions necessary to recapitalize the company, all when time is precious. Accordingly, managing stockholder relations is an essential stabilization challenge.

2.6.2 Managing the Burning “Regulatory” Fuse

According to Rajan (2000) when a bank becomes distressed, pressure from its regulators increases and management can find itself spending more time managing to the regulators’ demands than managing the business. This is particularly true when a distressed bank is downgraded in its risk rating and one or more of its regulators impose a regulatory enforcement action. Particularly onerous regulatory enforcement orders can charge the bank by increasing its capital levels over a short period of time or significantly reducing its NPAs or both.

According to Bikker and Hu (2002) finding additional sources of capital quickly is the remedy for both ills, but often, if the bank has not moved quickly enough in the early stages of its distress, it simply runs out of time and the bank tumbles fairly quickly in the final months into receivership. Fundamental to successful recapitalization transactions is managing the regulatory risk the bank faces, which involves, anticipating the bank examiner’s next major moves and restoring credibility with the bank’s regulators through improved communication, straight talk and delivering on promises. In the triage of a distressed bank, understanding where the bank stands in relation to the budgeted capital standards is critical.

But even more critical Danielson et al (2004) suggest, is having a third party expert forecast balance sheet and regulatory events that can depreciate the bank’s capital levels to below adequately capitalized and the timing of those prospective downgrades. In the opinion of Rochet (2008) this pro forma analysis will give management and the board an opportunity to time the launch of the recapitalization and assess how much time the bank can afford to spend in the preparation stages of the recapitalization. Ideally, the regulators will be presented with a well thought through recapitalization plan that reflects preparation, tangible progress and reasonable prospects for success. Conversely, “concept designs” for a recapitalization plan that reflect a hastily conceived plan will not impress the regulators and will not buy the institution more time.

Early on in the bank turnaround program, Diamond (2001) notes states the CEO or Credit Risk Officer (CRO) needs to assess the regulatory risks the bank faces, prioritize those risks and, as mentioned, find a reliable estimate of the time remaining before the bank becomes critically undercapitalized. Armed with this information and forecast, the CEO or CRO can develop a strategy for engaging the regulators going forward and mitigating regulatory risk. In all cases, regulatory risk management is integral to preparing for and successfully accomplishing a recapitalization transaction because, in the end, a recapitalization is a race against time. Many banks have failed because they simply ran out of time.

Capital and liquidity in the view of Flannery (2005) are precious commodities when a bank is distressed, but time is the most precious commodity. Taking proactive steps in a turnaround program to extend the useful life of a failing bank by three months or six months can make the difference between having sufficient time to prepare for and execute a recapitalization transaction or not.

2.6.3 Finding Investors

According to Danielson et al (2004) recapitalizations are only successful when institutional investors put up millions of dollars to save the bank, and finding those investors is challenging. Private equity firms and other institutional investors receive numerous “pitch books” every week, and there is an underlying skepticism that the burn down analysis is unrealistically optimistic. Therefore, to attract bona fide investor interest, a recapitalization candidate needs to support its burn down analysis with credible third party credit intelligence and craft a “use of proceeds” story that differentiates the bank from the hundreds of other banks canvassing the same universe of investors for capital.

In the view of Flannery (2005) the competition for capital is intense and will only grow more so as more banks experience deterioration in capital levels and regulatory pressure and bank failure rates continue to climb. Not all investment banking firms are created equal and care needs to be taken in interviewing and selecting the best firm for the particular situation facing the bank. Consideration needs to be given to the firm’s prior recapitalization experience, the amount of capital that needs to be raised, whether national or regional institutional investors will be tapped and the capacity and resources of the investment banking firm to manage the capital-raising process at the time the process needs to be launched?

The investment banking firm in the view of Bikker and Hu (2002) will play a pivotal role in helping the CEO or the CRO (in advance of the new CEO taking over) develop the “story” for the pitch book and position the bank as an attractive investment opportunity. This is so because the investment bankers will understand, unlike most members of senior management or the board, how the private equity community and other institutional investors view these types of transactions in terms of risks and rewards. The investment banker will give advice on the type of security or securities that should be used and the type of offering that will be most effective, including, for instance, supplementing a capital raise from private equity firms with a rights offering to current stockholders.

According to Berger (1995) these decisions are fundamental to the success of the

recapitalization and undoubtedly will affect the rights and interests of the current stockholders as well as any senior secured lender, trust preferred securities holders and the Treasury. Careful consideration ought to be given to all of these constituencies as the board identifies, with the advice of its financial advisor, the critical pathway for a successful recapitalization transaction. That advice, coupled with legal advice, will support the board’s exercise of its business judgment and is essential to proper management of the board’s fiduciary obligations.

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