Guest post from Jonathan Rochford, CFA, Portfolio Manager Narrow Road Capital Pty Ltd

As Basel III changes to bank capital levels are being announced and implemented there’s been a surge in articles on bank capital levels. How much capital is required, what type of capital is required and how minimum capital levels should be measured and set are all hot topics. Banks complain that having to hold more equity will reduce their returns and thus means they have to charge customers more. Governments want strong banks, so that they and their voting taxpayers don’t have to pay the bill whenever a bank strikes trouble. Every proposal comes with a cost, but which give the most bang for buck?

lehman photo
Photo by Red Carlisle

Why Banks Fail

In trying to figure out how to stop banks failing it helps to start with an understanding of why they fail. There’s two basic risks that banks need to watch out for, solvency and liquidity.

Solvency is having meaningful positive equity on the balance sheet, that is assets exceed liabilities. Solvency can be improved by raising more equity (stock offerings or dividend reinvestment plans) or by retaining profits. Solvency is reduced by bad loans and investments, which become bad debt expenses on the profit and loss statement and write-downs in the value of assets on the balance sheet. For banks, negative equity almost always comes about from lending to borrowers who can’t repay their loans and thus the bank incurs losses on those loans. It is typically the corporate and institutional departments that do the most damage with personal lending lower risk.

In Spain and Ireland in the lead up to the financial crisis lending for property development skyrocketed. Developers often contributed limited equity and when property markets crashed the developers were left with property they couldn’t sell and thus defaulted on their loans. Banks were caught with large amounts of failed loans, and for many banks the losses on these loans overwhelmed their equity. This experience is fairly common, Sweden and Australia both experienced a property and banking crash in the early 1990’s.

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Another practical example of solvency issues was the US subprime lending crisis. Whilst this involved residential loans, it was mostly losses in the corporate and institutional departments on securitisation structures containing subprime loans that caused some large US and European banks to fail or to require bailouts.

The second key risk for banks is liquidity. Liquidity issues arise as a result of banks undertaking maturity transformation, which is taking short term deposits and lending out them out for longer terms. Customers want to deposits funds with banks and earn a positive interest rate whilst being able to withdraw the funds at short notice. Borrowers need long term loans to purchase property and equipment for their personal or corporate uses. Banks provide a service to the economy by bridging the gap between the two.

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Experience has shown that maturity transformation is a dangerous business. Rumours of a bank having solvency issues are enough to start a rush for the exits by depositors, which can snowball once pictures of people lined up outside bank branches hits the news. The financial crisis showed panics can quickly spread globally, with all banks being considered suspect once a few failed. Once one government offered deposit guarantees, others were obliged to do the same or risk seeing a rush for the exits on the banks in their country.

What are the main capital ratios and how do they work?

The complexities of bank capital requirements can quickly overwhelm even seasoned investors, analysts and commentators. As a result, much of what is written about capital ratios is wrong or misleading and the debate about capital levels becomes a convoluted mess. It doesn’t help that there’s little evidence based modelling on the costs and benefits of higher capital ratios. Banks often fill the void with alarmist statements that the cost of lending will soar and economic growth will collapse if they are required to hold even a little more equity.

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However, out of this quagmire came a recent article by Mike Konczal that summarises what the capital ratios are trying to fix. He explains that there are three areas to focus on; leverage, risk weighted assets and liquidity. These align with the balance sheet components of equity, assets and liabilities respectively. His neat summary chart is below. In the following paragraphs there’s an explanation on what each capital ratio is and what potential problem it is trying solve.

Why Banks Fail

Source: Roosevelt Institute

Leverage Ratio: The leverage ratio is the simplest and most transparent of the three key ratios. It is the amount of equity relative to total assets, expressed as a percentage. For instance, a bank with $5 of equity and $100 of assets would have a leverage ratio of 5%. The standard leverage ratio includes just the ordinary equity capital of a bank, ignoring preference shares (additional tier 1 or AT1) and subordinated debt (tier 2). An extended version of the leverage ratio includes these items and is used for calculating total loss absorbing capital (TLAC) ratios.  

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The leverage ratio is trying to solve the problem of banks not having enough capital to cover potential losses on their loans and investments. Prior to the financial crisis, some banks had leverage ratios of only 2-3%. With so little equity, it wasn’t going to take much of a financial storm to wash away a bank’s solvency. In the case of Lehman Brothers, it combined a very low leverage ratio with high levels of risk taking in its lending and investments, including leveraged loans, mezzanine debt and equity investments in property and Lehman Brothers funds.

Risk Weighted Assets Ratio: The risk weighted assets ratio is similar to the leverage ratio in that it measures the percentage of non-senior capital relative to assets. However, the denominator (the bank’s assets) are adjusted for the perceived risk. Government debt is often (wrongly) considered to be risk free and usually attracts a 0% risk weight. Home loans are considered low risk and can adjusted down to 15-50% of their actual exposure. Business loans are seen as medium risk and typically marked at 100% of their exposure. Equity investments are considered very high risk and usually attract a 300-1250% risk weighting, which at the high end implies that they are to be fully funded

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