How Risky Are the Big Banks?

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Basel capital standards are the main tool used by regulatory authorities to evaluate the adequacy of bank capital and balance sheet strength. But according to Thomas Hoenig, vice chairman for the Federal Deposit Insurance Corp., this is no more than “a well intended illusion.” How much risk are banks really taking?

A Well Intended Illusion

Such is the title of the insightful speech Hoenig gave to the International Association of Deposit Insurers in Basel, Switzerland on April 9 explaining why we need simpler and more effective methods to measure financial strength when it comes to the big, systematically relevant, global banks.

In his words:

Here’s how the illusion is created. Basel's Tier 1 capital measure is a bank's ratio of Tier 1 capital to risk-weighted assets. Each category of bank assets is weighed by the supervisory authority on a complicated scale of probabilities and models that assign a relative risk of loss to each group, including off balance sheet items. Assets deemed low risk are reported at lower amounts on the balance sheet. The lower the risk, the lower the amount reported on the balance sheet for capital purposes and the higher the calculated Tier 1 ratio.

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights. The objective is to maximize a firm's return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This "leveraging up" has served world economies poorly.

Since Basel standards are flawed and subject to manipulation, the author proposes a simpler and more straightforward risk measurement method: the tangible leverage ratio. This ratio compares equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets. In addition to including only loss-absorbing capital, it also makes no attempt to predict or assign relative risk weights among asset classes

Measuring Risk

The following table summarizes some statistics regarding five US banking giants: Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC).

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It compares Basel Tier 1 capital ratios to the tangible leverage ratio using both US GAAP and IFRS – International Financial Reporting Standards – accounting rules. IFRS numbers are particularly interesting when it comes to this comparison, because they bring off-balance sheet derivatives into the balance sheet, painting a more complete picture about a firm's leverage.

The difference is remarkable, and it says a lot about how misleading Basel standards can be. Wells Fargo has the lowest Tier 1 ratio in the group, but it has much higher tangible leverage ratios, especially when it comes to IFRS accounting rules.

If we measure capital in a “risk adjusted” Basel Tier 1 fashion, both JPMorgan and Bank of America come ahead of Wells Fargo by a small margin, while Citigroup and Goldman Sachs look much safer than Wells Fargo.

When using IFRS tangible leverage, however, things are dramatically different: Wells Fargo's capital levels are roughly double those of its competitors.

The Value of Simplicity

There is one big difference when it comes to risk management at Wells Fargo versus its competitors. The bank is well known for its simple approach to the business, avoiding the intricate investments and complex derivatives that practically collapsed the entire financial system during the 2008/2009 credit crisis. Management stewardship is clearly better than at the other banks judging by recent experience, and it´s precisely because of a simple capital allocation strategy – moderate debt levels and easily understandable investments – that Wells Fargo has consolidated its reputation as the safest among the big American players.

Basel Tier 1 ratios include multiple complex assumptions about the possible risks of different kinds of assets. Considering what happened with the credit crisis in the US or, even more recently, with the sovereign debt crisis in Europe, it has become quite clear that past performance is a poor predictor of future results. Not bank managers, nor regulators, have been able to adequately forecast and plan for a crisis scenario, and there is really no reason to believe they will get it right this time.

According to Hoenig, back in 2007 the 10 largest US banks reported Tier 1 capital ratios that, on average, exceeded 7% of “risk weighted” assets. That was believed to be enough by regulators, but it represented an average tangible leverage ratio of only 2.8%. We all know how that ended.

Bottom Line

If we want to make sure that the banks are prepared for a crisis, maybe relying on a more straightforward risk measure like tangible leverage is a better idea than putting too much faith in financial models trying to predict the possible behavior of different kinds of assets during a crisis. The Basel III proposal includes leverage ratio requirements, but it calls for it to be only 3%, which has already been proven insufficient in a severe scenario.

It looks like the big US banks, with the notable exception of Wells Fargo, are still exposed to too much risk, even if they meet Basel capital requirements.

Andrés Cardenal owns shares of Bank of America. The Motley Fool recommends Goldman Sachs and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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