NEW YORK - Equity ratios, i.e. the ones now being discussed in Basel are a horrible way in judging the safety of a bank. There is little correlation between a banks tier 1 ratio and its ability to survive. The ratio is calculated by taking common equity less special deductions and inclusions divided by risk weighted assets.
However regulators are using equity ratio as another excuse for laziness. The regulators simply do not understand that raising capital ratios to ridiculous amounts hurt the economy more than it protects it.
Consider this National City Corporation has an 8.3% tier 1 ration in 2004 it failed. Wachovia had a capital ratio of 7.5% before it had to be merged with Wells Fargo. Citigroup had a ratio of 8.6%. Wells Fargo had one of 8.96% in 2006 and it was perfectly fine. Washington Mutual had one of 8.3% As can be seen a leverage ratio makes absolutely no sense. The first problem is that a bank can not properly recognize or know its loan losses. For instance when Wachovia was acquired by Wells Fargo, Wells Fargo wrote of $18 billion. Or when PNC bought NCC they wrote off $12 billion. A company like Synovus Financial has a current tier 1 ratio of 8.6%. However the company has been slower to recognize provisions for loan losses in recent times. The longer it takes to recognize provisions for losses the higher ratio a business has.
Another company Preferred Bank a small company in California took no provisions for loan losses in certain quarters which creates a higher tier 1 ratio. A further example of this is Allied Irish Bank. The company had a tier 1 ratio of 7.5% in 2007 and even in 2009 the company had a tier 1 ratio of 7.2% (includes government money). However there ratio has substantially been reduced and will be reduced further as the bank recognizes loan losses. A bank can keep an artificially high tier 1 ratio by underestimating its loan losses. The point is the ratio in 2007 did not include a realistic view of loan losses nor did it in 2008 and 2009 for AIB.
PNC has just acquired Royal Bank and plants to write down the value of its loan book by $1 billion. The problem is the Tier 1 ratio is based on the banks assumptions of its loan book and there is no way to regulate this.Another example of a high tier 1 ratio being over 20% caused massive problems is with Hudson City Bancorp. The company boasted a tier 1 ratio of over 20% but because it had large amount of debt the company has had to cut their dividend and it received notices from the Office of Thrift and Supervision (OTS)
Because of these inherit limitations and the little correlation on capital and risk there is little point with adopting regulation on capital ratios. Capital ratios being raised are once again regulators favoring laziness over doing their job. A company can have a tier 1 ratio of 50% but if all there loans drop to 0 then the company will crash. The banks that survived and thrived are the banks that made high quality loans.
As Buffett states in the video below, capital ratio while they should be set at a minimum cannot be controlled by numbers. The banking regulators like Sheila Bair are approaching regulation in the wrong way. Instead of thinking they will use mathematics to solve all answers. Instead of realizing the world we live in is subjective and professional judgement needs to be applied, we will paint the whole financial sector with the same incorrect brush. Furthermore worldwide capital standards are even more of a joke when one realized that every country defines risk weighted assets the denomination differently. The U.S. has more risk weighted assets while a country like Canada sees its banks have higher ratios because the banks have lower multipliers on their assets lowering their risk weight. This of course makes international financial standards impossible. Canadian banks also thrived during the crisis with lower ratios than their U.S. peers.
While there will need to be regulation going forward it should come in oversight and identifying a company's ability to judge their loan book in good and bad times. However the current financial framework is a step in the wrong direction. Dodd Frank are trying to hurt these institutions instead of finding the real problems
Warren Buffett comments on capital ratios below.
However regulators are using equity ratio as another excuse for laziness. The regulators simply do not understand that raising capital ratios to ridiculous amounts hurt the economy more than it protects it.
Consider this National City Corporation has an 8.3% tier 1 ration in 2004 it failed. Wachovia had a capital ratio of 7.5% before it had to be merged with Wells Fargo. Citigroup had a ratio of 8.6%. Wells Fargo had one of 8.96% in 2006 and it was perfectly fine. Washington Mutual had one of 8.3% As can be seen a leverage ratio makes absolutely no sense. The first problem is that a bank can not properly recognize or know its loan losses. For instance when Wachovia was acquired by Wells Fargo, Wells Fargo wrote of $18 billion. Or when PNC bought NCC they wrote off $12 billion. A company like Synovus Financial has a current tier 1 ratio of 8.6%. However the company has been slower to recognize provisions for loan losses in recent times. The longer it takes to recognize provisions for losses the higher ratio a business has.
Another company Preferred Bank a small company in California took no provisions for loan losses in certain quarters which creates a higher tier 1 ratio. A further example of this is Allied Irish Bank. The company had a tier 1 ratio of 7.5% in 2007 and even in 2009 the company had a tier 1 ratio of 7.2% (includes government money). However there ratio has substantially been reduced and will be reduced further as the bank recognizes loan losses. A bank can keep an artificially high tier 1 ratio by underestimating its loan losses. The point is the ratio in 2007 did not include a realistic view of loan losses nor did it in 2008 and 2009 for AIB.
PNC has just acquired Royal Bank and plants to write down the value of its loan book by $1 billion. The problem is the Tier 1 ratio is based on the banks assumptions of its loan book and there is no way to regulate this.Another example of a high tier 1 ratio being over 20% caused massive problems is with Hudson City Bancorp. The company boasted a tier 1 ratio of over 20% but because it had large amount of debt the company has had to cut their dividend and it received notices from the Office of Thrift and Supervision (OTS)
Because of these inherit limitations and the little correlation on capital and risk there is little point with adopting regulation on capital ratios. Capital ratios being raised are once again regulators favoring laziness over doing their job. A company can have a tier 1 ratio of 50% but if all there loans drop to 0 then the company will crash. The banks that survived and thrived are the banks that made high quality loans.
As Buffett states in the video below, capital ratio while they should be set at a minimum cannot be controlled by numbers. The banking regulators like Sheila Bair are approaching regulation in the wrong way. Instead of thinking they will use mathematics to solve all answers. Instead of realizing the world we live in is subjective and professional judgement needs to be applied, we will paint the whole financial sector with the same incorrect brush. Furthermore worldwide capital standards are even more of a joke when one realized that every country defines risk weighted assets the denomination differently. The U.S. has more risk weighted assets while a country like Canada sees its banks have higher ratios because the banks have lower multipliers on their assets lowering their risk weight. This of course makes international financial standards impossible. Canadian banks also thrived during the crisis with lower ratios than their U.S. peers.
While there will need to be regulation going forward it should come in oversight and identifying a company's ability to judge their loan book in good and bad times. However the current financial framework is a step in the wrong direction. Dodd Frank are trying to hurt these institutions instead of finding the real problems
Warren Buffett comments on capital ratios below.
Buffett on Banking Regulation begin at 1:30
Great piece! It takes a wise investor to take industrial measures with a grain of salt and an even wiser one to know why.
ReplyDeleteAt the national level, many of these regulations are approved by our congressmen who are as likely to be economically illiterate as they are politically literate.
ReplyDeleteAt the international level, blanket standards are a folly, no two country's banking systems are alike and neither are their risks.
Buffet mentioned we need a strong, smart regulator. But why would intelligent university grads go to work for the SEC for $50,000, when they can ten times as much in the private sector?
Either way, good thoughts.