Modigliani and Miller Theorem,

Order Description

Background:
The capital structure of a firm is a result of many factors. However, according to the Modigliani and Miller Theorem, the valuation of a listed corporation is independent of its capital structure. In other words the value of a firm is indifferent to the amount of debt or equity in its capital structure. This clearly satisfies the proponents of more debt or more equity.
In practice, we find a lot more debt in the capital structures of corporations than would be expected if the M & M thesis was applicable. It is argued that this is because of the preferential tax treatment of debt as opposed to equity. There is also a preferential treatment of debt over equity in the event of bankruptcy. It is argued that in the absence of these two anomalies, one would see more equity in the capital structure of corporations.
Post the Global Financial Crisis (GFC) it is further argued that in the case of banks, more equity should be mandated to avoid massive taxpayer funded bailouts. Thus, the Basel III accords have proposed much greater equity in banks capital structures. Indeed, Tier 1 capital is now required to be made up of “loss bearing” capital if not pure equity capital. Banks have responded with the launch of a number of instruments including contingent convertible (Co-Co) bonds. These Co-Co bonds convert into equity under stress conditions.
Islamic finance has always preferred risk-sharing capital and therefore is much more favourably disposed to “loss bearing” non-equity capital in the absence of pure equity.
The assignment is designed to explore the various forms of debt capital used by banks in particular. It is further designed to explore the types of “debt” capital instruments developed by Islamic Financial institutions before the GFC. Finally, it is designed to get students to examine the development of non-equity “loss bearing” capital post the GFC and see if there is a convergence between the conventional and Islamic finance on these issues.

Required:
1. Explain what you understand by bonds, “covered” bonds and Contingent Convertible (Co-Co) Bonds. In particular, examine the treatment of each of this debt structure in the event of bankruptcy. In addition, discuss the difference between preference shares and Co-Co Bonds. Lastly, examine what are the difference situations in which these different bond structures are used.
[20 Marks]
2. Sukuks are often referred to as “Islamic” Bonds. Define Sukuks as referred to by the Auditing and Accounting Organisation of Islamic Financial Institutions (AAOIFI). Trace the development of Sukuks and explain what you understand by asset backed and asset based Sukuks. Which category of Sukuks is more prevalent in the market? In particular, examine the structure of ijarah (lease) based Sukuks. Critically examine the reasons for this. Do these meet the AAOIFI definition of Sukuks? Are asset based Sukuks closer to conventional bonds?
[20 Marks]

3. In its statement in 2008, AAOIFI outlined two main objections to the developing Sukuks structures. These were said to be a fixed coupon and purchase undertaking. Explain how both these two features are achieved in a typical Sukuks structure. Critically examine AAOIFI objections and discuss how they would impact on future Sukuks structures. In this context discuss the development of hybrid Sukuks structures to accommodate AAOIFI objections. [You may want to look at the Ijarah structure as a more amenable contract than a Mudharaba or Musharakah structure to overcoming these objections]
[20 Marks]
4. Following the GFC and the advent of the proposed BASEL III capital adequacy accords the idea of “loss bearing” non equity capital has taken on an added significance to meet Tier 1 Capital requirements. Critically discuss of an asset backed Sukuks structure without a purchase undertaking would meet the test of “loss bearing” non-equity capital? Further, by reference to the Tier 1 Perpetual Sukuks issuances by the Abu Dhabi Islamic Bank (ADIB) and other Islamic banks, analyse if these structures are closer to the original concept of Sukuks.
[20 Marks]
5. Critically examine the developments in the non-equity part of the capital structures of conventional and Islamic banks. Is the concept of “loss bearing” non-equity capital similar in both cases? Can both these parts of the global banking system share similar “loss bearing” debt instruments? How would you expect these developments to influence the price of this kind of capital and the behaviour of banks and their shareholders?

additional guide:

I would like you to address the questions below (5000 words in total divided into two equal parts of 2,500 words each) and equal weighting of each element (a & b) of 50%.

a) Consider one national system of banking regulation (i.e. the form of financial regulation employed in a single nation state)

i. Outline how this form of regulation developed, its features, aims and form.
ii. Critically discuss the success and/or challenges of this national system of banking regulation.

b) ‘Banks are international in life, but national in death’ (quotation attributed to Mervyn King and Charles Goodhart).

Critically discuss the implications of the statement for the form and focus of banking regulation in light of the preceding discussion in a).

Some suggested readings are outlined below and are included in the library section of the blackboard website. Students are welcome to contact the module organiser to clarify any concerns as to the requirements of the question posed for this assignment
Suggested readings
Bullard, J. Neely, C. J. and Wheelock, D. C. (2009). “Systemic Risk and the Financial Crisis: A Primer”, Federal Reserve Bank of St Louis Review, September/October, Part 1, pp.403-417.
Carvajal, A., Dodd, R., Moore, M., Nier, E., Tower, I. and Zanforlin, L. (2009). “The perimeter of financial regulation”, IMF Staff Position Note SPN/09/07.
Goodhart, C.A.E. (2008). “The boundary problem in (financial) regulation”, National Institute Economic Review, 206, pp.48-55.
Levine, R. (2012). “The Governance of Financial Regulation: Reform Lessons from the Recent Crisis”, International Review of Finance, 12(1), pp. 39–56.
Masciandaro, D. (2006). “E Pluribus Unum? Authorities’ Design in Financial Supervision: Trends and Determinants”, Open Economies Review, 17, pp.73-102.
Schoenmaker, D. 2011. “The financial trilemma”. Economics Letters, 111(1), pp.57-59.