top of page

How to understand capital ratios

BY SIMON GILBERT


In our meetings with clients, the three most common words are “a”, “the”, and “capital.” And it’s not surprising: some of the main considerations banks face are regulatory capital requirements. These minimum requirements define the economics of the business of banking and, therefore, are and always will be a focus for the industry, its non-bank competitors, regulators and lawmakers: the House Financial Services Committee has held multiple hearings covering new capital rules to align U.S. banks with Basel III within the past month. So understanding how capital requirements work is critical to understanding banking and the regulatory environment.


Before we dive into the details of capital requirements, it would first be useful to understand why these requirements are in place and carry so much weight. With FDIC deposit insurance, banks can borrow from depositors as if they were the U.S. Treasury. Absent capital requirements, banks would have no incentives to minimize equity and maximize leverage. If the bank fails, the FDIC is on the hook for depositors up to $250K per account and is in charge of liquidating the bank. But if the bank doesn’t fail, it will have an exceptionally high return with minimal investment. This is a classic “tails I win, heads you lose” quandary resulting from deposit insurance. Capital requirements are a tool to address that quandary.


This logic is more than theoretical. During the Savings and Loan Crisis of the 1980s, hundreds of depositories, weakened by unrealized losses as the Fed increased rates (analogous to the current environment) and unburdened by effective capital requirements, pursued this exact strategy, leading to a banking crisis that required hundreds of billions in taxpayer funds to resolve. One price of that bailout was a minimum capital regime that, with periodic increases, still governs our banking system today (my colleagues Konrad Alt and Brian Graham were involved in the creation of those rules). Bank capital requirements are designed to ensure that investors and management have an incentive to run the bank prudently.


Four Capital Ratios


Regulators use measures of a bank’s assets as a proxy for risk. If a bank has more assets, regulators perceive the bank as riskier, and thus require that institution to hold more capital. This relationship is expressed through four ratios, where two definitions of assets are the denominator and three definitions of capital are the numerator.


For many traditional banks, the relationship between assets and risk is reasonably consistent. But it is important to note that the risks inherent in business models that are asset-light – like mortgage banking, investment banking, and partnerships – may not be well reflected in capital ratios.

  • Tier 1 Leverage Ratio: This ratio measures tier 1 capital divided by average tangible assets for a given financial quarter.

  • Common Equity Tier 1 Risk-Based Capital: This ratio measures tier 1 common equity divided by risk-weighted assets.

  • Tier 1 Risk-Based Capital: Here, the ratio is tier 1 capital divided by risk-weighted assets.

  • Total Risk-Based Capital: This ratio is total capital (i.e., tier 1 and tier 2 capital) divided by risk-weighted assets

The regulatory capital requirements for banks and bank holding companies are as follows:

In practice, given the regulatory scrutiny involved with dropping below well-capitalized, banks treat well-capitalized requirements as a minimum and operate with cushions materially above these thresholds.


These capital standards apply to both banks and bank holding companies. The definitions and minimum requirements are consistent. However, the fact that the Federal Reserve has only established a definition of well-capitalized for holding companies in excess of the minimum requirements with respect to total risk-based capital levels means that, in practice, holding company capital requirements relative to bank requirements are both a) less stringent overall and b) lean more heavily on total risk-based capital. Since total capital includes subordinated debt and preferred stock, subject to limitations, this difference in requirements creates incentives for holding companies to utilize such instruments. The holding companies can then inject those funds into the subsidiary bank as common equity. The result is that banks almost never raise subordinated debt, but many holding companies do.


Assets


Tangible Assets: These are all the assets on a bank's balance sheet minus most intangible assets, primarily goodwill. Goodwill is an asset that is created when a bank buys another company for a purchase price that exceeds the net asset value of the acquired firm (which is essentially always the case unless the acquired business is not generating value).


Risk-Weighted Assets: Not all assets carry the same risk. For instance, a treasury bill inherently has less credit risk than an unsecured consumer loan. In the 1980s, the banking regulators, with their international counterparts, implemented a framework that seeks to adjust the dollar amount of assets to reflect relative risk. In this framework, which does not apply to larger banks (these banks must use so-called advanced and model-based approaches to adjust risk weightings) the breakdown of risk weighting is as follows:

  • 0% risk weighting: obligations such as bonds from the U.S. government and a few other OECD countries

  • 20% risk weighting: Agency (e.g., Fannie Mae and Freddie Mac) debt and guaranteed mortgage-backed securities

  • 50% risk weighting: Residential mortgages (subject to loan-to-value and private mortgage insurance parameters) and HELOCs (if the latter is the first loan secured by the property and has a loan-to-value below 50%)

  • 100% risk weighting: Everything else (e.g., C&I loans, SMB loans, and even highly-rated corporate debt)

Notably, standardized risk weighting adjustments effectively only factor in credit risk, not interest rate risk. For instance, a U.S. T-bill with a 1-year duration has the same risk weighting as a T-bill with a 5-year duration, even if holding the latter involves more interest rate risk than holding the former. Certain disfavored assets, such as residential mortgage servicing rights, may be assigned risk weightings well above 100%.


Capital


Generally, capital is assets minus liabilities. The three primary measures of capital for regulatory purposes are defined as:

  • Common equity tier 1: This is defined as common shareholder equity (i.e. excluding preferred stock) minus most intangibles. Regulators permit all but the largest banks to elect to “add back” unrealized losses that are reflected in accumulated other comprehensive income on the balance sheet.

  • Tier 1 Capital: This is the sum of common equity tier 1 capital, certain types of perpetual preferred stock, and certain minority interests.

  • Tier 2 Capital: This encompasses all other eligible capital line items, such as subordinated debt and non-perpetual preferred stock, other minority interests, and a portion of the allowance for credit losses.

Implications


Although the four capital requirements discussed above help ensure banks remain solvent, they do not guarantee it. Notably, they do not account for changes in the market value of loans or bonds. Without accounting for unrealized losses, banks may seem more solvent than they actually are. For instance, as interest rates dramatically increased over the past year, many banks accumulated unrealized losses stemming from their bond portfolios. SVB – which remained well-capitalized up to the day it failed – was one of those banks. Thus, while capital standards may be indicative of a bank’s health, they are far from comprehensive.



Image by quimono @ Pixabay

Comentarios


bottom of page