Hey everyone, I have a very random question about something that I heard today. Now I can't remember the exact reasoning, and it's bugging the shit out of me. The premise is this: Banks need to keep a certain % of reserves on hand to prevent a bank run. During the recent crisis, banks faced a liquidity crises and thus needed more equity capital. They got that from the government, which decided to become a stock holder (preferred in the case of banks and common in the case of auto manufacturers, I believe). The thing that's tripping me up is this: A speaker said today that bond financing would not have worked, because the money raised would not have been considered capital (something like that?)? From the company's point of view, how is the bond and stock financing different? Couldn't they just use the money that they raise from either a bond or a stock sale? If anyone knows what I'm talking about (apparently I dont), then I'd appreciate your help.
There are a few key differences: - Bonds are debt - Bonds typically require payment of an interest coupon, then the principal amount at maturity - Bond holders have priority over shareholders (equity investors) - Equity investments show up as share capital on the balance sheet If a company raises $1,000,000 by issuing bonds (debt), the immediate impact to the balance sheet would be that cash would increase by $1,000,000 (less debt issue costs), and long-term debt would increase by $1,000,000. Any increase in assets (cash) has been cancelled out by the increase in debt (bonds)...the two essentially cancel each other out. Let's say that the same company instead raises $1,000,000 by issuing shares (equity), the immediate impact on the balance sheet would instead be that cash would increase by $1,000,000 (less equity issue costs), and share capital would increase by $1,000,000. In this case the assets (cash) of the company have increased by $1,000,000, but no debt has been added to the balance sheet. There are currently a couple of tiers for calculating Basel reserves, Tier I consists of shareholder equity (and other things). Thus, issuing shares immediately boosts your Tier I reserves. Bonds being issued (depending on type) may not have been considered as Tier II reserves.
I see. So I assume that the money raised from a bond issue would be Tier II capital and thus probably wouldn't count as unimpaired capital? Ok, that makes perfect sense! Thanks!!!