Policy debates about banking regulation often revolve around an understanding (and occasionally misunderstanding) of bank capital. While capital can be the most important indicator of a bank’s financial strength, the concept is not always well understood. Some assumptions about capital adequacy rely more on folk wisdom than evidence. Here are six observations about bank capital.
Capital is a confusing term. For a concept so central to banking regulation, the word “capital” is hardly unambiguous. “Capital” can mean a factor of production, a required rate of return (“capitalization rate”), or an investment. Bank capital is often confused with reserves or liquidity. In fact, capital is just a bank’s net worth – its assets minus its liabilities. We usually express capital as a percentage of assets, though regulators may tweak the numerator or denominator. In fact, when I started with the Federal Home Loan Bank system, we referred to capital and its regulation as “net worth” and “net worth requirements.” Capital was commercial bank terminology that the other regulators eventually adopted.
Capital regulation periodically goes through cycles of reform, relaxation, and repair. The 1980s were something of a golden age of dubious capital components. As I noted in an earlier post, thrift regulators propped up capital ratios through a bunch of questionable accounting practices. But this practice wasn’t limited to those supposedly crazy, captured thrift regulators. Just as crazy was how commercial bank regulators approached loan loss reserves. These reserves are supposed to cover expected losses. But until FIRREA came around, regulators counted loan loss reserves as primary capital.
A 1987 news story from the New York Times illustrates how little sense this policy made. Citi increased its loan loss reserves by $3 billion, “essentially acknowledging that a good part of its $14.7 billion in third-world loans would not be repaid.” The increase in reserves caused shareholders’ equity to drop from $9 billion to $8 billion, but its capital to rise by $500 million. In other words, the bank could add the loss reserves back to capital. Regulators continue to include loan loss reserves in capital, albeit in a diminished form. (Current regulations restrict ALLLs to Tier 2 capital and limit them to a percentage of risk-weighted assets.)
The quality of bank capital is better now than it was in the 1980s. However, we usually follow reform of bank capital standards by a relaxation of those standards and further abuse. We no longer have deferred loan losses or appraised equity capital, but still have derivatives, structured investment vehicles, collateral netting, and held-to-maturity portfolios. Some see capital reforms as a Sisyphean task since bankers are so darn clever that they’ll figure out a loophole to every new rule. While there are plenty of clever bankers, Congress and regulators often serve (wittingly or unwittingly) as their enablers. Someone had to write the loophole in the first place and the idea usually came from the banking industry itself.
There’s a reason for multiple requirements. Banks face multiple capital requirements that generally fit into two broad categories: leverage and risk based. The balance between the two can change over time. The leverage standard divides capital by total assets.[1] Relying solely on a leverage ratio ignores the composition and risk of the balance sheet.
There are also problems with relying solely on risk-based requirements. I recall one bank that decided to invest in 30-year Treasuries and fund with 30-day repos. The strategy was crazy but would require zero additional risk-based capital even under today’s requirements. Other banks combined GNMAs, repos, and hedging that could even make the interest rate risk (IRR) numbers look okay. The trouble is that it doesn’t account for operational risk or imperfect risk measures. You need a leverage standard to ensure at least some minimal level of capital. A leverage requirement for U.S. banks dates to 1989, but a similar requirement for European banks did not become effective until 2021.
Consider the denominator. Most capital ratios are stated as a percentage of risk weighted assets (RWA). RWAs are almost always less than actual assets and quoting ratios in those terms can overstate the level of capital. RWAs primarily reflect credit risk. Combining high credit risk with other risks means there are more ways things can go wrong.
But low credit risk doesn’t necessarily offset to other risks, such as IRR. I dealt with a bank in the 1990s whose assets primarily consisted of fixed rate agency CMOs that it funded largely with short-term borrowings. The bank’s IRR ratios were through the roof, projected to lose more 100% of capital if rates rose just 200bps. OTS had also proposed to add IRR capital component to the risk-based requirement. However, since its risk-based ratio was also high due to the low denominator, the bank was also would remain well capitalized even after the IRR component.
Well Capitalized isn’t that special. Regulators categorize banks as undercapitalized, adequately capitalized, and well-capitalized. Some activities, like brokered deposits, are directly tied to a bank’s capital status. More generally, well-capitalized banks face fewer regulatory limits and “well-capitalized” is a sign of financial strength in the public’s mind. It’s useful to remember, however, that more than 99% of banks meet the well capitalized standard. It’s nothing special and not unlike grade inflation. Consider that 91% of Harvard’s Class of 2001 graduated with honors. Sure, getting into Harvard is impressive. Graduating with honors, not so much.
I’ve found through the years that examiners are reluctant to adversely rate capital if a bank meets well-capitalized thresholds. SVB, Signature, and First Republic all received satisfactory “2” ratings for capital prior to their collapse. While liquidity was the proximate cause of their failures, the fact that these banks cost the FDIC billions to resolve suggests that capital levels were less than adequate to absorb losses.
The concept of a “fortress balance sheet” is more about marketing than financial strength. Jamie Dimon often refers to JP Morgan Chase’s as having a “fortress balance sheet.” Banking observers often repeat this phrase as though it were an unassailable fact. True, the bank has a cheap deposit base, a diversified balance sheet, and solid earnings. But is JPMC’s balance sheet such a fortress? Dimon started using this phrase as early as 2008. Meanwhile, the bank’s residential mortgage portfolio had a past-due and nonaccrual rate of over 10% from September 2009 through September 2013.
Asset quality ratios are better now but JPMC is much more leveraged than the average bank. JPMCs supplemental leverage ratio (SLR) is 6.67% while the median leverage ratio for all banks is 10.87%. Comparing the SLR (which only applies to the largest banks) to the leverage ratio is not a strict apples-to-apples comparison. However, it also makes little sense to ignore the leverage associated with a $50 trillion (with a “t”) derivatives portfolio. The SLR tries to take account of a fraction of that exposure. Most banks have little or no derivatives exposure. The point is not to pick on Dimon or JPMC. As the chart below illustrates, the largest banks in general are much more leveraged than the typical bank or even the vast majority of banks.
A better understanding of bank capital can put the debate around various regulatory initiatives in perspective. The firestorm around the FDIC’s proposed changes to its brokered deposit regulations largely ignores that the regulation affects only a tiny percentage of the country’s worst capitalized banks. The consequences of becoming less than well capitalized may also prompt some banks to become less dependent on brokered funds or to build larger capital buffers. But that’s also just prudent risk management.
Similarly, opposition to the Basel Endgame suggests the proposal will represent a significant increase over “already robust requirements” and that large banks are “well capitalized and highly resilient to economic downturns.” It’s true that bank capital levels are stronger than in 2008, but that’s a low bar. While the government didn’t really end too big to fail, the idea was to make the financial system sufficiently strong so that banks would never again need a 2008 style bailout. The country’s largest banks still leverage, or about 60% more than the typical bank. And big banks still fail.
[1] To make matters more confusing, the amount of a firm’s leverage is the reciprocal of its leverage rate. A lower leverage ratio translates to a higher degree of leverage.