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To follow the euro zone crisis requires some knowledge of bank capital ratios [ClearOnMoney]
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To follow the euro zone crisis requires some knowledge of bank capital ratios

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Commentary

To follow the euro zone crisis requires some knowledge of bank capital ratios

2 Nov 2011 by Jim Fickett.

In debating the current risks at euro-zone banks, or the pros and cons of various rescue schemes, measurements of bank capital adequacy often come up. This post explains the leverage ratio and capital ratios involving risk-weighted assets. The goal is to explain the main ideas without getting into too much detail.

All banks take some risk. Even carefully researched loans to creditworthy recipients can go bad. So banks need to have some capital that they can afford to lose. All regulatory regimes have some sort of requirement on the capital ratio – the bank's capital divided by its assets. Branching out from that simple idea, there are infinite complexities, as there are many ways to measure each of capital, assets, and risk. The purpose of this post is to give a simple introduction to a few of the main concepts.

Global regulatory context

Each country has its own regulatory context. And even within one country, different regulators may supervise different institutions. A simplified view of the situation in the US is that the Federal Reserve regulates bank holding companies, the Office of the Comptroller of the Currency regulates nationally chartered banks, and the FDIC and state regulators supervise banks chartered by the states.

Every regulator has its idiosyncrasies, but there is some degree of national and international coordination, mainly through the so-called Basel Committee on Banking Supervision. This committee is “staffed mainly by professional supervisors on temporary secondment from member institutions”, and is hosted by, but not formally a part of, the Bank for International Settlements. The Basel Committee formulates recommendations, which have no legal force but are usually adopted, at least to some degree, by the participating countries. In particular, the Basel Committee recommendations form a primary conceptual framework for regulators in the US and Europe.

There have been several iterations of recommendations from the Basel Committee. The two that are currently most important are Basel II, a comprehensive framework issued in 2006 and currently in force, and Basel III, currently under discussion but already impacting policy, as it will be phased in beginning next year.

A compilation of the main Committee documents includes the “International Convergence of Capital Measurement and Capital Standards” which, in 347 pages, details the Basel II framework.

Capital

In the context of bank regulation, capital should be something the bank is free to use to cover unexpected losses.

Core capital, or tier-1 capital, is primarily equity capital. There is some variation in concepts of core capital. Here is the Basel II definition:

The Committee considers that the key element of capital on which the main emphasis should be placed is equity capital [issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock] and disclosed reserves. This key element of capital is the only element common to all countries' banking systems; it is wholly visible in the published accounts and is the basis on which most market judgements of capital adequacy are made

And from the FDIC:

Core capital – common equity capital plus noncumulative perpetual preferred stock plus minority interest in consolidated subsidiaries, less goodwill and other ineligible intangible assets.

(The “reserves” in the Basel definition must be uncommitted; this excludes most of what is usually call “loan loss reserves”, as these are largely dedicated, by definition, to estimated losses.)

Tier-2 adds to tier-1 a number of assets for which the bank may have some soft obligation to use the money in other ways. This includes, for example, cumulative preferred stock.

There are many refinements of the above two concepts, but the main idea is simple enough. Just remember that tier-1 capital is quite conservatively defined, while tier-2 is softer.

Risk-weighted assets and capital ratios

The very simplest capital ratio is (core capital)/(total assets). This is usually called the leverage ratio.

The leverage ratio does not differentiate between assets with different levels of risk. Whatever you think of US government debt and its future, it remains the case that a 5-year US Treasury bond is much less likely to default than a 5-year sub-prime auto loan. To reflect the fact that riskier assets naturally deserve more capital backing, the Basel II standards include the idea of “risk-weighted assets”.

The basic idea is this: (1) Each asset is given a risk weighting, usually between 0% and 100%, that one can think of as the fraction of the asset that needs to be insured by holding capital. Then, (2) some overall capital ratio is required, but that ratio is applied only to the risk-weighted fraction of each asset. For example, a prime residential mortgage is given a risk-weighting of 35%:

Lending fully secured by mortgages on residential property that is or will be occupied by the borrower, or that is rented, will be risk-weighted at 35%. In applying the 35% weight, the supervisory authorities should satisfy themselves, according to their national arrangements for the provision of housing finance, that this concessionary weight is applied restrictively for residential purposes and in accordance with strict prudential criteria, such as the existence of substantial margin of additional security over the amount of the loan based on strict valuation rules. Supervisors should increase the standard risk weight where they judge the criteria are not met.

So a bank that is required to have a 10% capital ratio against risk-weighted assets would, for each $100 of prime residential mortgages held, have to hold only $3.50, not $10.00, in capital.

You might have been forgiven for wondering, back in 2008, why banks had kept so many CDOs on their books. The answer comes exactly in capital requirements. Prime mortgages had a risk weighting of 35%; sub-prime would have a higher risk weighting. But securitized tranches of sub-prime mortgages, if rated AAA, had a risk-weighting of only 20%:

The risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the position by the appropriate risk weight determined in accordance with the following tables. … AAA to AA-, 20%

Of course the basic idea of risk-weighting is very sensible. There is no doubt that it is appropriate to hold more capital against risky assets than against very safe assets. But problems came in because the system is extremely complex and banks took advantage of that to hold much less capital than was really needed.

Newspaper reporters are somewhat careless with capital ratio terms. Usually if you see “tier-1 ratio”, “risk-weighted capital”, or something similar, it means the ratio of tier-1 capital to total risk-weighted assets. Risk weightings can occasionally exceed 100% (which essentially means that they require a higher capital ratio than the overall one applied to the bank), but are almost always lower, so the ratio of tier-1 capital to risk-weighted assets is always higher than the leverage ratio.

Current context

A first example of how all this is relevant to the current context is the recent downgrade of Italy. Under Basel II sovereign debt rated AAA to AA- (in S&P notation) is given a risk weight of 0% – a bank can hold as much AA sovereign debt as it likes without holding any capital against possible losses. For sovereign debt rated A+ to A-, however, the risk weight is 20%. On 4 Oct, Moody's downgraded Italy's debt from Aa2 to A2 (S&P notation AA to A). If Moody's rating were the only consideration, risk weighted assets would have suddenly increased by 20% of the nominal value of Italian debt, with bank capital ratios thereby reduced. In the real world Moody's is not the only rating that matters, but the downgrade still increased the likelihood of lowered capital ratios.

As a second example, here is an observation on French banks meant to illustrate why some investors see as inadequate the current plans to increase the capital buffer of European banks (from Gene Frieda of Moore Europe Capital Management, on Project Syndicate):

For example, French banks’ risk-weighted assets are €2.2 trillion, against a capital base of €167 billion – just above the 7.5% ratio established by the international Basel 2 rules. But, once risk weights are removed, assets balloon to €8.1 trillion (roughly 400% of GDP), and the equity-to-asset ratio plummets to 2%. Wholesale debt funds only 10% of these assets, but amounts to €841 billion, or 41% of French GDP.

In the event of a loss of market confidence, state guarantees for that much funding would further strain market perceptions of French creditworthiness, generating more pressure on French banks to shrink their balance sheets rapidly. And France is one of the stronger countries in the eurozone!

The latest agreement between European Union member states forces banks to raise core “Tier 1” capital levels to 9%, and will apparently require €108 billion of additional capital. But this figure is well below market expectations, as it is based on the Basel 2 rules, which have proven deficient in terms of risk weights and capital “quality” during the crisis.

The argument runs something like this:

  1. Since total assets are so much greater than risk-weighted assets, there is a suspicion that banks are once again gaming the system
  2. With a leverage capital ratio of only 2%, it is quite likely that losses could push the bank into unsafe territory very quickly
  3. In addition, there is a liquidity concern; with 10% of assets funded by short-term borrowing rather than long-term debt or deposits, funding could quickly disappear with any loss of confidence
  4. If the French government had to step with even a temporary guarantee of 41% of GDP, that would likely cause a significant drop in confidence, and probably a downgrade as well, for French government debt
  5. If French sovereign debt were downgraded, the bank capital ratios would be further degraded, starting a vicious cycle