Why and How do Banks Raise Capital?

Why do banks need to raise capital
“How do banks raise capital” is a question that is best understood by looking at the basics of a bank. Just as a business sells its products or services as its main line of business and thus its survival; a bank has the business of lending and recovering from customers at the core of its raison d’ etre. To make the question of how do banks raise capital easier, let us think of money as the raw material for a bank’s business. If a manufacturing firm such as textile business has to assemble raw materials that start with cotton, a bank has only money that it plans to lend to its customers as its raw material.

The money that a bank raises to lend is often called the capital. So, how do banks raise capital is something that has to be understood in this background. Banks have to raise money from sources in order to have it with them to be lent to customers, from whom they charge a rate of interest that is higher than that at which they borrow.  This accounts for their profit. Since capital is one of the critical components of a banking business, it is important to understand where all and how to banks raise capital.

Capital from stakeholders
Banks can do this in a number of ways. The most common, and in fact, a mandatory method of raising capital is for the organizers (in most cases, these are the stakeholders or founders) of the bank to put in money from their pockets. Usually, while the amount needed to start a bank varies from one American state to another, the ratio at which banks get their capital from their organizers varies between 10 and 15 percent. These organizers are the investors in the bank, and have a deep interest in the functioning of this lending institution. How do banks raise capital is understood in a clearer fashion in this context –the greater the ability of the organizers to raise money, the greater the money the bank can lend out , so that it runs healthily and profitably.

Raising capital from shareholders
While organizers make up between 10 and 15 percent of the bank’s investment, how to banks raise capital is understood when it is seen that the reminder of the money is raised from shareholders. The term ‘shareholder’ implies those who invest in the bank through public borrowing.  The number of shareholders and their individual contributions can vary by a very wide margin, as can their contribution. As with any other kind of partnership, this kind of financial relationship too, is such that every stakeholder earns from the profit in proportion to the investment made.

The markets as lending source for capital
How do banks raise capital is a question that can be answered in another manner. Banks look for other sources in raising capital. For instance, they can borrow from the financial markets. This option is usually exercised in free market, capitalist economies, a prime example of which is the US. In these economies, it is a useful source to have someone borrowing from the markets because this can be used as a buffer in markets, which by their very nature are volatile and prone to a lot of flux. When markets are in need of money in case of a crunch, they can always go back to the banks to which they have lent money. Of course, there are some drawbacks in this system for both the lender and the borrower. The lender may not be fully sure of getting back money it has given to banks when it needs it the most, since they normally ask money back from banks only when it is faced with an emergency, and it is always difficult to get it at such short notice. For banks, too, there are problems with this kind of option, because they cannot invest this money on long term plans.

The government as a source of capital
Getting money from the government is another option for banks when it comes to how do banks raise capital. In governments in which the free market is less powerful a force to reckon with, government bonds can be a good source by how do banks raise capital. In economies that are either fully or partly controlled, as in the case of China or India, government lending can be a very useful source of how do banks raise capital. This is a lesser possibility in free market, consumerist economies such as the US, but more common in the countries just mentioned. In these situations, governments lend banks through bonds and other sureties for a number of reasons. Since it is not always the consumer who dictates demand, governments lend banks as a kind of safety valve. When the key sectors of the economy, mostly agriculture in these and other related countries, face problems, the governments can straightaway approach these banks to which it has lent capital and direct them to divert the money due to the governments back to the people in need of the money. In most cases, this is usually a case of money transfer. In other words, the question of how do banks raise capital needs to be looked at from a different perspective in some countries.

Other ways
How do banks raise capital is to be understood when it one looks at another queer way by which banks raise capital. In the days of the economic slowdown, some financial companies came to banks to advise them on how to raise capital. The aim was to get these banks to impart their experience to these companies on how to liaise with the government and get money from it. These companies, such as Wells Fargo and Morgan Stanley, had to pay a huge consultancy fee for these bankers. There were also some financial arrangements by which these banks got a cut in the amount of money they helped the companies raise! The money that these banks got from these transactions was put back into the market and other sources, as this too, turned out to be its capital in many ways. In this way, how do banks raise capital was a question that was answered in a very unusual fashion.