NEW YORK - Politicians, are quoting tier 1 ratios which should be required for the financial sector as if god came down and chose for them a correct number. Equity ratios are a very poor and lazy way to judge a banks safety. There is little correlation between a banks 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 will be required to hold more capital than demanded by Basel III..
In 2008, Citigroup lost $31 billion according but with dividends in 2008 and their loss in stocks not yet sold they really lost Citigroup was $56 billion. The company started the year $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 according but with dividends in 2008 and their loss in stocks not yet sold they really lost Citigroup was $56 billion. The company started the year $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 daringly 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 if it was designated a SIFI. 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.
The second problem with the new Basel Regulations and SIFI is that banks around the world determine the numerator 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 had nearly a 10% ratio that collapsed and there is little correlation between the good and bad banks in relation to tier 1.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 Hudscon City Bancorp has over $900 million in nonperforming loans but only has an allowance for loan losses of $750 million. A bank from California Preferred Bank, which operates in one of the hardest hit areas and has over 10% of their loans nonperforming took no provisions for loan losses in certain quarters last year. 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 $80 million of deposits and $80 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.
The difference is the quality of the institution itself and it 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.
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 predictor of failure and success.
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