Author: Gus Wilkinson

The too-big-to-fail problem refers to the issues that arise when a large bank is so pivotal and engrained in the financial system, that its failure would be detrimental to the economy as a whole. But how has this problem come about? And what can realistically be done to combat this ever-present issue? This article will attempt to answer these questions as well as exploring the government bailout of RBS as evidence of the problem. 

What is it?

As previously mentioned, the too-big-to-fail problem comes down to the systematic importance of large banks, and how the failure of one of these banks could cause major damage to both the financial system and the wider economy. The gargantuan costs associated with the failing of a large bank or financial institution motivate policy actions in order to prevent the failure. Although the cost of ‘bailing out’ (using public funds to avoid failure) a bank can be enormous, the effects of a bank failure are argued to be much more costly. The general consensus is that large banks failing can lead to contagion effects. This is where troubles that effect one bank may be transmitted to another bank through the interbank market, leading to a deterioration in the financial system. Commercial banks may also suffer the consequences of bank runs, where depositors look to withdraw cash due to a lack of confidence, leading to liquidity shortages. Some would argue that these effects should be avoided at all costs, giving rise to the idea that large banks are too-big-to-fail.

What is the problem?

The problem with having banks that are viewed as too-big-to-fail is the creation of moral hazard. This is the economic idea that an individual or entity does not have to bear the costs of their actions. For too-big-to-fail banks, because the government or regulatory body will not allow them to fail, these banks have an incentive to take on more risk. The benefits of this is the potential of greater returns on investments. However, in the event that taking on more risk backfires, the resulting extreme losses can be destructive for the government and the economy, who would have to pay for the bank’s mistakes. In this way, the assumed-protection of too-big-to-fail banks at the expense of the government may actually lead to financial instability in the long term.  

How has it come about?

The term ‘too-big-to-fail’ was first coined during the failure of Continental Illinois (a US commercial bank) in 1984. The bank’s extensive relationships with both retail and corporate clients meant that a bailout was almost inevitable once the bank had found itself in financial difficulty. [1] This pushed the too-big-to-fail problem to the forefront of financial regulatory debate. Since then, greater availability of credit in the 1990s and increased diversity of services offered have enabled tens of banks to grow in size and be considered too-big-to-fail. [2] The difficulties in solving this problem have also furthered the extent of the issue, as a lack of effective action means the problem worsens as time goes on.   

How do we measure it?  

The size of a bank is the general characteristic used when determining whether or not it is considered too-big-to-fail. Although there is no universal threshold, legislation in the US gives a strong insight into whether or not a bank or financial institution should be considered in this way. The infamous 2010 Dodd-Frank Act characterised a systematically important financial institution as one with $50bn or more in assets. At the time of introduction, this meant that 38 banks operating in the US were indirectly thought of as too-big-to-fail, although this threshold has since increased. [3] Thus, it is clear that there are numerous banks that, in the event of failure, could wreak havoc for the financial markets. Despite being a useful indicator, it could be argued that it is not just overall size which should be taken into account. Though difficult to measure, the influence that a bank has should also be considered, especially when some institutions are more heavily intwined in the commercial banking sector.

RBS – A case study

The UK government bailout of RBS in October 2008 is a pristine example of a bank being too-big-to-fail. For a short period, RBS was the biggest bank in the world by assets. [4] Thus, it can be understood why the government thought it necessary for the bank to be bailed out when it found itself in financial trouble. The reasons behind this financial trouble really highlights the assumed nonchalant attitude of too-big-to-fail banks. Although there is a plethora of reasons for RBS’s failure, the banks huge overall exposure to risk emphasises the moral hazard at the time. Arguably, it could be said that the need of a government bailout came as a consequence of this moral hazard, created from the bank being too-big-to-fail. The case study of the failure of RBS is not only an excellent example of how the actions of too-big-to-fail banks lead to their failure, but also how the government reacts to their failing. 

What are the potential solutions?

With a contentious topic like the too-big-to-fail problem, there is much debate about what can be done to solve the issue (if there is anything at all). One of the first solutions to come to mind may be to put a cap on bank size. However, this does not come without its issues. Choosing the level at which the cap should be would be a near-impossible task and would cause a whirlwind of debate amongst some of the banks near the proposed cap. Another issue with a size cap is that banks may have to narrow their range of services which they offer to meet the new requirements. This could be an issue to the banks customers as well as the bank itself, who could experience hardship as a result of decreasing revenue streams.
An alternate remedy to the too-big-to-fail problem may be to enhance financial regulation of large banks. This may reduce the risk appetite that a bank chooses and potentially decrease the risk of failure. An integral point about regulation though is the cost of it. With the estimated cost of regulation in the UK at around £1.9bn, there is little scope to increase this figure, especially when considering the strain that the COVID-19 pandemic has had on public finances. [5]
Evidently, it is clear that the popular solutions to this ever-growing problem are not without their limitations. 

To summarise, the too-big-to-fail problem is only going to grow as banks get larger, and little to nothing is done to remedy the situation. The issues in measuring whether or not a bank is characterised in this way, as well as the problems involved in regulating banks which are already engrained in the financial system, put substantial limitations on ideas which could solve the overall problem. In the long term, it will be interesting to see how financial regulation is curated to chip away at the too-big-to-fail problem.

Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance

Financial Distress refers to the financial situation of an entity (whether that is a company or individual) which is struggling or unable to pay their bills. More often than not, a lack of capital to finance loan payments to creditors is the main cause of financial distress. This can happen for many reasons and can be challenging for all parties involved. The COVID-19 pandemic has brought this topic to the forefront of corporate finance once again, with over 550,000 businesses in significant distress. [1] This article will explore how financial distress comes about as well as looking at the variety of responses that can arise as a result. 

How does it happen?

There are many different ways in which a firm can become financially distressed. Although, generally speaking, these ways can be categorised into three areas. 
Firstly, the economic or industry environment can play a huge role in how financially sound an entity is. If the economic environment is prosperous, then we can expect firms to also reap the rewards and move further away from any type of financial distress. On the other hand, economic uncertainty can impact a firm massively in a number of ways. Uncertainty in the economy connotes an aggregate decrease in demand as a result. Consequently, the revenues of firms decrease and there is a lack of cash inflow. This reduces the amount of capital that firms have to pay their overheads (such as rent, insurance, loans etc.) and can potentially lead to a struggle in getting these bills paid. Therefore, poor economic or industry conditions can certainly increase the risk of a firm experiencing financial distress.
The second way in which a company may become financially distressed would be because of business management. This looks at the methods used by the company to increase revenue, such as new product ranges. However, sometimes the methods used in making this money can backfire. In other cases, it can be a lack of action taken by the company which leads to their demise. This was the case for Motorola, who were once one of the major players in the cellular phone industry. [2] A lack of product development in the mid-2000s allowed the likes of Blackberry and Apple to take control of the market. Confidence in the company fell to the extent that shares in Motorola plummeted by 90% between 2006 and 2009 highlighting one of the biggest business errors ever. [3] Therefore, it is clear that poor business management can really negatively impact a company. In the case of Motorola, little product development meant a lack of sufficient revenue to keep the company going at the levels that it once operated. Although the company is now a subsidiary of Lenovo, it has never returned to the highs experienced in the 1980s and 1990s. [4]
Finally, the financial management of a company can play an enormous role in whether a firm is successful, or if it is financially distressed. Financial management involves ensuring that there is sufficient cash on hand at the company to meet their current obligations. A company can be performing well in a market, and still become financially distressed due to a lack of quality in managing their finances. Ultimately, if the money on hand is insufficient to pay its current obligations, it spells trouble for the company.

What can it lead to?

As financial distress is a broad term, the consequences of it for companies are endless. The final strategy for a financially distressed firm would be to wind up the company, though there are many policies which can be implemented before this to avoid having to shut up shop completely. Generally, it comes down to how long the company is distressed for which dictates what response the company takes to solve the problem. There is a huge list of turnaround strategies which may be used, but these are some of the more prominent choices.
Firstly, a firm may look to mitigate risk and distress by expanding in size. This looks to increase levels of production and sales by merging or acquiring other companies. However, this expansionist policy is very expensive, and may only prevent financial distress in the short term.
Another policy used would be to contract the operations of the business. This is where a company chooses to focus on its most profitable ventures, whilst closing or selling-off the less profitable portions of the business. This is a method of cost reducing which looks to decrease cash outflow, so present obligations can be met. 
Sometimes a firm may use financial policies (such as reducing annual dividend payments or debt restructuring) to have more cash on hand to pay for their present obligations. Though this can be a quick solution to access cash, many investors use dividends and debt restructuring news as a signalling function. This means that a reduction in dividend payments, or news of debt restructuring, may lead to a fall in the share price of the company because the market believes that the company is experiencing problems. In this way, a company may try to avoid this policy.
Other than winding up the company altogether, the final main policy would be to change managerial control. This normally goes alongside other forms of restructuring, but a company may look to remove current managers as they may have played a role in distressing the company. Thus, new management may be preferred.

Financial Distress at Carillion

The bankruptcy and eventual closure of UK construction firm Carillion in 2018 is an excellent example of a firm experiencing financial distress to the point of no return. With a debt pile of £1.5bn and a global workforce of 43,000, the closure of the company was not taken lightly. Many argue that the company had taken on many risky contracts which proved to be unprofitable, such as many delayed hospital projects around the UK. After multiple warnings in 2017, the firm’s lenders were reluctant to give the firm any more cash and it was decided that the firm would be forced into liquidation. [5] Carillion were found to be underestimating the amount of funding needed to reverse the company’s fortunes and did not have any contingency plans for incomplete projects. In this case, it was poor debt management which led to the collapse of such a large and nationally important firm. [6]

In summary, financial distress can come about for a variety of reasons, some of which cannot be avoided. There is a huge number of responses to a firm being distressed, from simply tightening budgets to catastrophic bankruptcy. The closure of Carillion is an excellent example of what not to do, especially if you find yourself in hot water.

Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance

Put simply, interest rates are the benefit you receive for saving, and the cost you incur for borrowing. Usually set by national governments or central banks, interest rates have a huge impact on various parts of the economy, particularly the financial markets. This article will explore in detail the impact that interest rates have on Equity Capital Markets (ECM), Debt Capital Markets (DCM) and the Forex Markets (FX Markets), before concluding with an overview of the current global trends in interest rate policy.  

The Equity Capital Markets (ECM)

Being a synonymous term for the stock markets, the equity markets (like most of the financial world) can be heavily impacted by changes in interest rates. This impact can occur for numerous reasons. Whilst evidence suggests that consumer and business responses to interest rates happen over the course of twelve months, the equity markets are a lot more reactionary.
In the event of an interest rate increase, it is generally expected for stock prices to fall. The fall in price results from two main factors: the cost of borrowing and the decrease in consumption. Increases in interest rates increase the cost of borrowing, making it more expensive for firms to finance future ventures which could negatively impact earnings. The equity market’s response therefore is for share prices to fall as investors sell their shares. Interest rate hikes also decrease consumption because saving is made more attractive. Consequently, with less consumers in the market, share prices fall due to the belief that a lack of consumption is going to decrease company earnings. 
When there is a decrease in interest rates, effectively the opposite happens. Share prices rise because borrowing is cheaper and so firms can invest more. Meanwhile, as saving is made less rewarding, consumers look to spend their money in the economy. Increased investment and greater consumption both lead to growth in firms, which is why the reaction in the stock market is a positive one.

Figure 1. Source: J.P. Morgan Asset Management [1]

 As seen in above in Figure 1, research by J.P. Morgan Asset Management suggests this generalisation to be valid. However, there are some anomalous sectors to interest rate changes. Most notably is the financial sector because whilst increases in interest rates may impact investment levels, banks are able to charge a higher rate for borrowing and so earnings could actually increase.  
In summary, when interest rates increase, generally expect a fall in the equity markets whilst when rates decrease, expect a rise in the equity markets. 

The Debt Capital Markets (DCM)

The Debt Capital Markets are another segment of the financial world which is greatly impacted by interest rate alterations. Mainly constituting Corporate and Government Bonds, this market is extremely reactive to even the slightest change because most bonds pay at a fixed interest rate. This means that when interest rates change, a bond’s value can either go up or down.
Bonds have an inverse relationship with interest rates, meaning that when interest rates go up, bond values go down and vice versa. A rise in interest rates means newly issued bonds would have a higher yield than those currently on the market, leading to a fall in price of the older bonds (known as a discount). On the other hand, falling interest rates make older bonds more attractive and increase their value, which is known as a premium. 
What influences the price of bonds is a hotly debated topic, however some believe the biggest risk to bond prices is interest rates and the associated interest rate risk. The theory hypothesises that the longer the time to maturity on a bond, the greater the interest rate risk because there is a greater chance that interest rates will fall below the yield of a given bond. Thus, the hypothesis is self-evident in emphasising the importance of interest rates in relation to the DCM. In the wake of the huge influx of debt issuance resulting from the COVID-19 pandemic, it will be interesting to see how future interest rates influence the value of this debt.

The Forex Market (FX Market)

The Forex Market is a decentralized market concerning the trade of currencies. Interest rates play a huge role in the FX market with slight adjustments making huge changes in the values of currencies. This impact ultimately comes down to what is known as ‘Hot Money Flows’. To explain this term, it is best to use an example.
Let’s suppose that interest rates in the UK increase. This boosts the return on saving in a UK bank account. Consequently, people look to put their money in a UK bank account to accumulate more interest on their savings. This increases the demand for GBP and leads to an increase in the exchange rate. In this way, a rise in interest rates equates a lot of the time to a hike in the exchange rate. It also works the other way around, wherein a fall in interest rates can lead to individuals looking abroad to place their savings somewhere they can get a better return. This would result in a fall in demand for GBP and decease the exchange rate.
When looking at fluctuations in the Forex markets, it is important to consider the impact that a change in one currency can have on another. Many currencies are fixed and may be pegged to others. An example would be Saudi Arabian Riyal (SAR) which is pegged to the USD. Therefore, changes in the interest rate in the US, if they effect the exchange rate, would also influence the value of the SAR. It is in this way that the impact of interest rate changes can have a ripple effect throughout the global economy.     

Current Trends in Interest Rates

The rates experienced today are at all-time lows. The Bank of England chose in March 2020 to cut the base interest rate to a historic 0.1%, emphasising the impact that the COVID-19 pandemic has had on investment and consumer confidence. [2] Across the Atlantic, the US Federal Reserve has chosen rates of 0%-0.25%. [3]There has also been speculation of negative interest rates though it is a hotly debated discussion. These significantly low rates look to gauge investment from companies to re-establish the health of the global economy. Resulting from this, if theory stands true, ECM and DCM should appreciate in the coming months whilst FX Markets may struggle. However, it is integral to bear in mind that foreign exchange rates are also affected by an array of factors such as politics and fiscal stimulus. Thus, the affect that these low interest rates have on the FX Markets may be limited.

Overall, it is clear to see the potential impact that interest rate changes can have on the financial markets. It will be interesting to monitor the performance of ECM, DCM and FX Markets in the coming months to see their response to any further changes in interest rate policy resulting from the COVID-19 pandemic. Will the markets bounce back to pre-COVID highs, or will the market uncertainty and volatility prevail?

Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance

A major topic of debate within Corporate Finance, the capital structure of a company refers to how they are able to finance anything that they do. Whether it be through debt or equity, the argument surrounds the pursuit for an ‘optimum’ capital structure, which would enable a company to fulfil financial goals whilst not taking on a huge amount of risk. This article will look at capital structure explaining its importance, current market trends and why it is so difficult to find this ‘optimum’ solution. 

What is capital structure?       

The capital structure of a company is all about how they finance their operations and growth opportunities. Made up of a combination of debt and equity, a company’s capital structure is integral to its success because it is what enables the firm to strive towards their economic goals, and pay their bills.
Debt has been used by companies for hundreds of years to finance a whole array of various avenues. A company’s debt is borrowed money being used in the business that at some point needs to be paid back. This debt generally comes in the form of loans or bonds, with most major companies using both forms. Though they are similar, there are some distinct differences between the two. With a loan, the company receives money from a creditor (usually a financial institution or an entity with sufficient spare capital) and agrees to pay interest on the loan on top of regular repayments back to the creditor. Bonds on the other hand are debt instruments sold by the company themselves to raise capital. Governments and investors purchase these bonds in return for a steady stream of payments over the bond’s ‘lifetime’ before receiving back their original payment at the end. The major difference however is that loans are usually non-tradeable meanwhile bonds can be traded on a market meaning their value can rise and fall. 

Equity refers to financing through the sale of stocks and shares. In choosing equity via issuing shares as method of finance, companies will have their shares listed on a stock exchange to be traded. Equity also covers retained earnings, which are previous amounts of money taken from profits which have been kept to finance future operations.

Why is the capital structure of a company important?

As previously mentioned, capital structure is one of the most important parts of a company’s success for multiple reasons. Firstly, it influences the return a company earns for its shareholders. If a company chooses to issue more shares and profit levels are maintained, the earnings-per-share (EPS, calculated by dividing income by the number of shares) would decrease because the same income is being divided up among more shares. This is an important consideration to be made because EPS is a popular metric used by investors to see if a share is worth purchasing or not. Therefore, by decreasing the EPS, a company could potentially seem less attractive to an investor which is the opposite of what a company wants.
Additionally, the capital structure of a company is a key point of analysis to see how a company would perform in the event of a market downturn or a recession. A company laden with debt is likely to struggle in the event of a downturn because sales may stall, meaning there is less cash flowing into the company and so paying creditors is more difficult. Consequently, bankruptcy may end up a more likely possibility. Similarly, an equity-heavy company struggling as a result of market conditions is also likely to experience uncertainty where shareholders are pulling out of the market, decreasing the overall level of investment in the company. Without sufficient investment, the company may struggle to meet its day-to-day costs (let alone finance future growth opportunities) which could lead to the gradual demise of the company.

Current Trends in Capital Structure

In order to look at the current trends in Capital Structure, we are best positioned to look at the bond and equity markets to gauge market sentiment. In a year unforeseen by all, the structure of companies has never been so important.

So far in 2020, the bond markets have been flooded with new debt. The COVID-19 pandemic has led to an overhaul in government stimulus packages as they looked to prop up the economy and financial markets. $525B worth of new debt has been created in Europe whilst new debt deals in the US have topped $1.2T [1]. This sends a clear message to the market that companies are looking to have sufficient cash on hand to fuel business and also to ‘ride the wave’ that the pandemic has caused in the global economy. The pandemic may have also led to an increase in bond values as falling dividends for some firms have meant investors look for alternate avenues of consistent income.

With bond markets flourishing, the fortunes of the equity markets are also beginning to turn. Despite market hysteria wreaking havoc earlier on in the year, 477 IPOs went ahead in Q3 topping the number of IPOs in Q1 and Q2 combined. Evidencing a clear desire of some firms to still go to market, the level of share offerings looks to continue into Q4 though the dark clouds of the US election and the possibilities of more lockdowns potentially put this scenario in jeopardy. [2]      

Is there an ‘optimum’ capital structure?

Evidently, the COVID-19 pandemic has led to changes in the capital structure of many firms. Over the past hundred years or so, there has been a huge topic of debate over whether or not there is an ‘optimum’ capital structure that a company should take in order to achieve the most they can, whilst also taking on as least risk as possible. Whilst many academics have seemingly found this equilibrium (where a firm’s Weighted Average Cost of Capital, aka WACC, is minimised), the consensus remains that it is up to financial managers and strategists to make such a decision. This is mainly due to the drawbacks of debt and equity that are sometimes ignored in these models made by academics. Debt may be easier to obtain than equity but also has colossal costs involved in the event of a loan default or bankruptcy. Likewise, the cost of issuing equity can be enormous with the average cost of an IPO coming between $8.2M and $25M, making obtaining equity harder. [3] With that said, the hunt for an ‘optimum’ capital structure will continue though, in the modern day, it seems like it is up to the discretion of managers to decide how debt and equity make up their company. 

In summary of such a vast topic, the capital structure of a company is one of the most pivotal decisions that can be made by financial managers. As seen over the past year, the state of the global economy and market conditions can change at any time and so it is ever-more important that a balance is made between debt and equity which permits success in the biggest way possible whilst limiting the effect of crises.

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Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance