NEW YORK - Politicians, are quoting new tier 1 ratios for the financial sector as if god came down and chose for them a correct number that would ensure all safety in this world. However, equity ratios are a very poor and lazy way to judge a bank's safety. There is little correlation between a bank's tier 1 ratio and its ability to survive. The vaunted tier 1 ratio is calculated by taking common equity less special deductions and inclusions divided by risk weighted assets.
Lets take a look at Citigroup in 2008 and see if they would have been able to maintain sufficient ratios if the tier 1 was 9.5% a popular number now being discussed by politicians with regards to the Systematically Important Financial Institutions (SIFI). SIFI institutions which will be regarded as more important than other banks because of their size and interconnectedness around the world and likely will be required to hold more capital than demanded by Basel III. Basel III is the banking regulation reform currently being discussed that will raise required capital ratios from 2.5% to 4.5% with a 2.5% buffer or 7%.
In 2008, Citigroup lost $31 billion but with dividends in 2008 and their loss in investment not sold (an accounting intricacy) they really lost $56 billion of capital. The company started the year with $89 billion in tier 1 capital. To have a 9.5% ratio the bank would have needed $114 billion in capital. The bank's equity dropped to $33 billion in 2008 or 2.6% before being bailed out by $70 billion in government preference shares. If the company had $114 billion of equity, a 56 billion dollar loss would have taken the company down to $58 billion or a ratio of 4.6%.
In 2008, Citigroup lost $31 billion but with dividends in 2008 and their loss in investment not sold (an accounting intricacy) they really lost $56 billion of capital. The company started the year with $89 billion in tier 1 capital. To have a 9.5% ratio the bank would have needed $114 billion in capital. The bank's equity dropped to $33 billion in 2008 or 2.6% before being bailed out by $70 billion in government preference shares. If the company had $114 billion of equity, a 56 billion dollar loss would have taken the company down to $58 billion or a ratio of 4.6%.
The first problem is the minimum ratio before the crisis was 2.5% which Citigroup was above in 2008 but was very close. In a future economic calamity Citigroup would be at 4.6% which would be daringly close to the new minimum of 4.5% but well below the 7% required of Basel III and even further below any SIFI amount. So the government would likely still intervene. This is what happens when common sense is thrown out the window. The thing to remember is as long as the minimum ratio keeps moving up the banks will be "safer" but in times of distress they will still need to be bailed out since they will need to keep higher ratios. If you work at a small shop and your manager requires you to count the cash at the end of the night and allows for a $5 fluctuation in value as being acceptable in the counting. By Changing that amount to 1 cent means that you will need to be more accurate. Meaning the same consequence happens now if you miss by 1 cent as opposed to before if you miscounted by $5. This will be similar to a bank. The governments around the world will bail out banks if their ratios dropped to 7% if they are required to be 10% when in the past they bailed out financial institutions when their ratios were 4% when they were supposed to be 7%. The same thing will happen with a new set of numbers.
The second problem with the new Basel Regulations and SIFI is that banks around the world determine the denominator of risk weighted assets differently. A Bank like Citigroup had $1.2 trillion of risk weighted assets in 2007 with 2.2 trillion of assets. RBC today has $727 billion of assets but it only has $253 billion of risk weighted assets. This means tier 1 ratios mean next to nothing for Canadian Banks but it can be disastrous for American banks. Bank of America has $1.45 trillion to $2.2 trillion in assets. While, PNC Financial has $216 billion of risk weighted assets to $259 billion of assets.
The third problem is that many banks that collapsed had higher ratios than being required. National City Corporation collapsed and was bought by PNC, before it fell it had an 8.3%. Wachovia had a capital ratio of 7.5% before it had to be merged with Wells Fargo. Citigroup had a ratio of 8.6% before it needed to be bailed out. Wells Fargo had one of 8.96% in 2006 and it was perfectly fine. Washington Mutual had one of 8.3% and was one of the earliest institutions to collapse.
The fourth problem is that common equity can be gamed. A bank like Hudson City Bancorp has over $900 million in nonperforming loans but only has an allowance for loan losses of $250 million. A bank from California Preferred Bank, which operates in one of the hardest hit areas and has over 10% of their loans nonperforming but they took no provisions for loan losses in certain quarters last year and in their most recent one. Lets go back to Citigroup, if the company decided to take no provision for loan losses in 2008 the company would have had $30 billion in more equity under accounting rules.
This leads into the next problem the regulators are mixing black and white with grey. The banking system is a grey area regarding loan losses but they want to standardize certain items such as risk weighted assets when other metrics are impossible to standardize.
Let us make an example bank. The bank raises capital it has $20 million of equity. and $150 million of deposits and $150 million of loans
FDIC Future Safe Haven Bank Balance Sheet
Assets
Long Term Investments ........................$20
Loans....................................................$150
Total Assets...........................................$170
Loans....................................................$150
Total Assets...........................................$170
Liabilities
Deposits................................................$150
Equity....................................................$20
Total Liabilities and Equity......................$170
Deposits................................................$150
Equity....................................................$20
Total Liabilities and Equity......................$170
The company would have a tier 1 ratio assuming everything is risk weighted 100% of 12%. Lets assume an economic crisis hits the nations and the bank also has long term investments in Greek Debt. The Long Term Investments drop to $10 and 6% of the loans go bad. Now the banks equity drops to $1 million and the company goes bankrupt.
Smart Bank
Assets
Long Term Investments ........................$20
Loans....................................................$150
Total Assets...........................................$170
Loans....................................................$150
Total Assets...........................................$170
Liabilities
Deposits................................................$150
Equity....................................................$20
Total Liabilities and Equity......................$170
Deposits................................................$150
Equity....................................................$20
Total Liabilities and Equity......................$170
Here is another bank which has investments in stocks and bonds that do not lose much value. Furthermore it makes high quality loans and only 2% of its loans go bad. So maybe the bank loses 3-4 million. The bank passes all tests easily.
Though investing in stocks is not similar but imagine someone has $20,000 and borrows $140,000 to invest in PNC Financial a solid bank. Or has $20,000 and borrows $140,000 to invest in Pandora. Both companies have the same leverage but one obviously has less risk.
Though investing in stocks is not similar but imagine someone has $20,000 and borrows $140,000 to invest in PNC Financial a solid bank. Or has $20,000 and borrows $140,000 to invest in Pandora. Both companies have the same leverage but one obviously has less risk.
The difference is the quality of the institution has little to do with its leverage. Leverage is just one metric to look at; the real important parts such as measuring loan quality and what assets the bank holds are being avoided.
One more example with Preferred Bank (PFBCD) . PFBCD had a tier 1 ratio of 12% in 2007 on $1.2 billion of assets. However the company had to raise $110 million of equity since then to just survive. The bank was very fortunate to have owners willing to contribute their own capital to save the bank. The bank still has an equity ratio of 12% but we calculate it as closer to 8% because it is not properly charging off loan losses. The company is doing such because the FDIC wants it to maintain a ratio of 10% or else it will seize the bank for being not adequately capitalized. So the bank is gaming the system and not recognizing loan losses and inflating their tier 1 ratio.
The key points
1) The tier 1 ratio has little correlation to safety. 2) It is a draconian and lazy way to measure safety 3) Large financial institutions or SIFI's are already safer because it is easier for them to raise equity in times of crisis 4) The banks ratio can be easily gamed. 5) The calculation is different across American and international companies. Royal Bank of Canada has almost no risk weighted assets while Bank of America has 70% of their assets being risk weighted. 6) The SIFI charge does nothing more than help politicians sleep and it will increase the cost of credit and the financial recovery. 7) The financial crisis was caused by other factors including the perception that home prices would never go down in value i.e. a bubble. Fannie Mae and Freddie Mac have lost over $200 billion. Capital ratios of 100% would not have saved them. The only way to fix the system is regulation on how banks make loans. The tier 1 ratio is a lazy and wrong way to go about this.
The main issue is a bank assets and there ability to survive varieties of stress tests. The U.S. banks that thrived were the ones who did not have a large amount of loans that defaulted and it was not determined by their tier 1 ratio pre-crisis.
One more example with Preferred Bank (PFBCD) . PFBCD had a tier 1 ratio of 12% in 2007 on $1.2 billion of assets. However the company had to raise $110 million of equity since then to just survive. The bank was very fortunate to have owners willing to contribute their own capital to save the bank. The bank still has an equity ratio of 12% but we calculate it as closer to 8% because it is not properly charging off loan losses. The company is doing such because the FDIC wants it to maintain a ratio of 10% or else it will seize the bank for being not adequately capitalized. So the bank is gaming the system and not recognizing loan losses and inflating their tier 1 ratio.
The key points
1) The tier 1 ratio has little correlation to safety. 2) It is a draconian and lazy way to measure safety 3) Large financial institutions or SIFI's are already safer because it is easier for them to raise equity in times of crisis 4) The banks ratio can be easily gamed. 5) The calculation is different across American and international companies. Royal Bank of Canada has almost no risk weighted assets while Bank of America has 70% of their assets being risk weighted. 6) The SIFI charge does nothing more than help politicians sleep and it will increase the cost of credit and the financial recovery. 7) The financial crisis was caused by other factors including the perception that home prices would never go down in value i.e. a bubble. Fannie Mae and Freddie Mac have lost over $200 billion. Capital ratios of 100% would not have saved them. The only way to fix the system is regulation on how banks make loans. The tier 1 ratio is a lazy and wrong way to go about this.
The main issue is a bank assets and there ability to survive varieties of stress tests. The U.S. banks that thrived were the ones who did not have a large amount of loans that defaulted and it was not determined by their tier 1 ratio pre-crisis.
Warren Buffett the legendary investor states that while there should be minimum ratios, there is no point enforcing excess ratios because it is not a great predictor of failure and success. What Mr. Buffett means is that the ratio is important to a certain extent. i.e at 0% it would be a great predictor of failure but between 6% and 10% there would be less of a correlation.
Maybe the dandys down at the the Group of Governors and Heads of Supervision (GHOS) should read this post and listen to a man like Bove. But no. Instead it will be --"For our next trick" --"We here at the global regulating dandy society reccomend a global government!"
ReplyDeletearticle linked
Thanks, I have a PDF version of the file I am sending it into the WSJ as an Op-ed piece.
ReplyDelete90% of the problem with banks were bad loans. The other problem was tier 1 capital included some weird assets before like Non Controlling Interests.
The new Basel Standards were a large step in the right direction but these new higher regulations are not good.
The funny thing is and one thing I did not mention is that the new regulation makes mergers and acquisitions very difficult which will lead to more bankruptcies.
PNC tier 1 dropped to 4.8% in 2008 but they did it so they could acquire National City. If PNC is a SIFI (which it wont be but lets say it is) then it wouldn't be able to acquire the company. Lets say its in bad times and its hard to raise equity and PNC's equity is at a bad price anyways so management does not have value in issuing it.
So the merger doesn't happen and NCC fails. So all the small banks that merged instead of failing now will fail in a future financial crisis.