The capital funding structure of a bank or insurer is defined by how much equity the group has available, how that equity is leveraged in order to finance the group's operating businesses and how capital and leverage resources are allocated and managed by the businesses.
The firm's funding structure has a direct influence on its solvency ratio, weighted average cost of capital, return on equity and shareholder dividend policy, with more equity implying higher solvency ratios and cost of capital but lower return on equity and dividend capacity. Although the subject of spirited debate, it is through these channels that the firm's funding structure has the potential to influence value. More specifically, balance sheet decisions influence both the quantum of capital required to finance the firm's operations as well as the cost of that capital. In addition, long-term funding forms the anchor around which the Treasury conducts cash and liquidity management activities.
This chapter focuses on how banks and insurers finance their investments in operating businesses along the debt-equity continuum; the allocation of economic capital from a value management perspective was discussed in Chapter 14.
There are many financing alternatives along the debt-equity continuum used to finance the firm's investment in operating businesses and as operating leverage. These alternatives include asset-backed financing (including mortgage backed securities, ...