Citicorp Case Study

Citicorp Case

1. What is the difference between primary and secondary capital. How is relevant to this case?

Primary capital consists of common stock, perpetual preferred stock, surplus, undivided profits, mandatory convertible instruments (debt that must be convertible into stock or repaid with proceeds from the sale of equity), reserves from loan losses, and other capital reserves. These items are treated as permanent forms of capital because they are not subject to redemption or retirement.

Secondary capital consists of nonpermanent forms of equity, included limited-life, preferred stock and subordinated notes and debentures.

It is relevant this case because Glass-Steagall did not prevent commercial banks from engaging in securities activities overseas. By the mid 1980s, US commercial banks such as Chase Manhattan, Citicorp and JP Morgan had thriving overseas securities operations. Currencies were not securities under the Glass-Steagall Act, but since exchange rates were allowed to float in the early 1970s, they have entailed similar market risk. In 1933, futures markets were small and transacted primarily in agricultural products, so they were not included in the legal definition of securities. By the mid-1980s, US commercial banks were subject to primary capital requirements set by the SEC, OCC and FDIC while US securities firms were subject to the SEC's Uniform Net Capital Rule (UNCR). The primary purpose of capital requirements for securities firms was to protect clients who might have funds or securities on deposit with a firm. Securities firms mostly took market risk.

2. Why do many country central banks count perpetual debt as primary capital?

Most Central Banks count perpetual debt as primary capital because it looks like equity, frs in balance sheet and is tax exempt. In the case of bank holding companies, both cumulative and non-cumulative perpetual preferred stock is included in primary capital. By allowing bank holding companies to include cumulative perpetual preferred stock in core capital, the Federal Reserve is allowing these companies more flexibility in raising capital while recognizing the value of perpetual preferred stock in the holding companies’ capital structure. At the same time, the limits on the maximum amount of preferred stock included are meant to protect the integrity of a holding company’s common equity capital base.

3. How are debt and preferred stock in the US treated differently by the Internal Revenue Service?

Preferred Stock is capital stock which provides a specific dividend that is paid before any dividends are paid to common stockholders, and takes precedence over common stock in the event of liquidation. Like common stock, preferred stocks represent partial ownership in a company, although preferred stockholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preferred stock is that the investor has a greater claim on the company’s assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. Preferred stock differs from fixed income instruments in their tax treatment. Interest payments are an expense, so they are tax deductible for the corporation. Dividends are distributions of earnings, so they are not tax deductible. Also, depending on the investor's tax jurisdiction, dividends may be taxed differently from interest income.

4. What is subordinated debt? How should it be “priced” relative to other debt?

Subordinated debt is an unsecured loan that has less priority to other loans with regard to claims or earnings. These funds are loaned based on the amount and predictability of cash flow exceeding that required to service senior debt. Interest costs can be anywhere from two to eight percentage points greater than rates on senior debt. Because subordinated debt usually has little collateral protection, the lending institution may be granted stock options to own equity in an amount equal to 1% to 10% of the outstanding stock. From a borrower's perspective, it is more flexible than bank debt and less expensive and dilutive than common equity. The price of subordinated debt typically includes a base interest or coupon rate on the loan with an additional pricing vehicle to ensure that the investor participates in the success or failure of the business.