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Our Take on Post-Crisis Capital Requirements for Banks

Here's our best guess about future capital requirements and the impact on the Big Four U.S. banks.

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Early signs of a recovery are starting to show in the banking industry's recent quarterly reports, suggesting the worst may finally be over. With the threat of a complete collapse of the United States banking industry retreating and bottom lines improving, investors are starting to look at the long run (a view they should have stuck to all along, in our opinion). Several questions linger, but the one that has us up at night is about regulation: What will the regulatory environment look like in another year or two?

While the Federal Reserve, FDIC, Office of the Comptroller of the Currency, Office of Thrift Supervision, Congress, the Treasury Department, and state bank regulators battle over who will ultimately regulate our banking system, we are more concerned with what those regulations will entail. What will the new capital levels be, and how will this affect shareholder returns?

Capital Requirements
Higher capital requirements almost seem to be a foregone conclusion. But which ones will be used, and how high will the new standards go? We compiled a list of the current requirements and the Dec. 31, 2009, capital levels at  Citigroup (C),  Bank of America (BAC),  Wells Fargo (WFC), and  J.P. Morgan (JPM), and we made our best guesses of post-crisis capital standards.

Tier 1 Ratio
Historically, the Tier 1 Ratio was the most prominent and important measure of a bank's regulatory capital ratios. In the U.S., the Tier 1 Ratio is defined as Tier 1 Capital--which includes common stock, retained earnings, some noncumulative preferred stock and trust preferred stock less goodwill and intangible assets--divided by risk-weighted assets. The regulators set the risk weighting for each class of assets and therefore determines how much capital must be held. Cash and U.S. Treasury bonds have a risk weighting of 0%--meaning the government believes the chance of default is practically nil. Loans, on the other hand, generally have a 100% risk weight. These weightings mean that for almost all banks, risk-weighted assets will be substantially less than total assets (this is not always the case, however, due to off-balance-sheet securitizations). The current standard to be considered well-capitalized is a 6% Tier 1 Ratio. Before the crisis it was common for banks to have a Tier 1 Ratio of 7%-8%. However, during this crisis, a Tier 1 Ratio closer to 10% became the norm. In fact, all four of the big U.S. bank's Tier 1 Ratios are above 9%.

Going forward, we expect the Tier 1 Ratio will continue to be a capital standard, but it will no longer be the most important metric. We expect the minimum 6% ratio will be raised to at least 8% or so. This presents no problems for Citigroup, J.P. Morgan, B of A, or Wells Fargo--each already holds more Tier 1 Capital than our expected higher regulatory minimum.

Leverage Ratio
A slightly less well-known required metric is the Leverage Ratio, defined as Tier 1 Capital divided by average total consolidated tangible assets. This metric continues with the same definition of loss-absorbing capital but eliminates the risk weightings. We believe this is a better measure of capital adequacy than the Tier 1 ratio as a result. To emphasize this, we need simply to go back to August of 2008 when  Fannie Mae (FNM) and  Freddie Mac (FRE) preferred securities went bust, leaving many banks scrambling. These securities were considered fairly safe and carried a risk weight of only 20% by national banks. Many banks loaded up on these securities knowing they would not have to carry much capital against them and could earn a nice return for their shareholders. But this weighting turned out to be much too low and, the Tier 1 Ratio really overstated the capital strength of heavy investors in Fannie and Freddie preferred securities.

Additionally, the leverage ratio has been targeted by regulators in the few memoranda of understanding (MOUs) that have been released to the public by some troubled banks. In these documents, regulators have targeted a leverage ratio of 8%, compared with the current well-capitalized standard of 5%. Since the 8% level is set for banks who are overwhelmed with bad loans, we believe the normal post-crisis well-capitalized standards will be slightly less than this--maybe around 6% or 7%.

The Leverage Ratio is one of the tougher capital standards for the big banks to meet, since their investment banks tend to hold billions of low risk-weighted securities. While the banks have a comfortable cushion on most of the likely new standards, only Wells Fargo (who has the smallest investment bank by leaps and bounds) has a nice cushion on the Leverage Ratio at 7.87%. The other three are on the fence depending on where the final standard falls--Citigroup 6.8%, J.P. Morgan 6.9%, and B of A 6.91%. A couple quarters of positive earnings and small dividend payments could bring this ratio higher and give the companies some breathing room, but it also means a greater capital burden to deal with. After all, we estimate the Big Four have a cost of equity between 10.5% and 11% compared to a cost of liabilities that is hovering much closer to 1%-1.5% in the current interest rate environment.


Total Capital Ratio
The Total Capital Ratio is the easiest ratio to stay in compliance with--mainly because its definition of capital is the broadest. The ratio is defined as Total Capital divided by risk-weighted assets. Total Capital includes Tier 1 Capital plus the allowance for loan losses (up to 1.25% of risk-weighted assets), any additional preferred stock that did not qualify as Tier 1 Capital, subordinated debt, and term preferred stock. Since sub-debt is fairly easy to issue during good times, the sub-debt component of this measure is why this ratio is not usually the first to get a bank in trouble. To be well-capitalized, a bank must have a 10% total capital ratio. This is likely to increase--we are guessing to 12%--when the new standards are set. This would be consistent with the few MOUs we have seen. We don't think this will be a problem for the top four U.S. Banks; all four have total capital ratios above 13%.

Tier 1 Common Ratio
The Tier 1 Common Ratio is quickly becoming the capital standard used by the market and (we believe) the regulators to assess capital adequacy. Currently, the ratio is not included in the required minimums to be considered well-capitalized. This ratio made its first big appearance in the SCAP--or stress tests--completed last May by the government. At that time, banks needed to prove they would have a minimum of a 4% Tier 1 Common Ratio (primarily defined as Common Equity and Retained Earnings minus Goodwill and Intangibles divided by risk-weighted assets) after two years of stress case losses. More recent rumblings, including the equity issue and TARP repayment by  PNC (PNC), suggests the Tier 1 Common Equity Ratio will need to be greater than 7% in the long run.

J.P. Morgan's 8.8% ratio already jumps the 7% hurdle rate with room to spare, as does B of A's 7.81%. Citigroup did not disclose this figure in its fourth-quarter 2008 press release, but our internal estimates suggest it is around 8%. Wells Fargo is the only major U.S. bank with a shortfall, coming in at 6.5%. However, if this standard is adopted, we believe the government would give companies time to reach this new minimum, and Wells Fargo's earnings power suggests it would be able to increase its ratio another 50 basis points in fairly short order without having to dilute shareholders with an additional equity raise.

Tangible Common Equity Ratio
Defined as Tangible Common Equity to Tangible Total Assets, the Tangible Common Equity Ratio is the only one an outsider can easily calculate. The Tangible Common Equity Ratio was almost never used by regulators before the credit crisis. However, it became a source for the market to gauge a bank's capital strength when the need for an easily understood metric--one that analysts could calculate--became evident. It is still used as a quick-and-dirty proxy for the Tier 1 Common Ratio discussed above.

We don't expect the Tangible Common Equity Ratio to enter into the well-capitalized standards, but we do expect the market to continue to use it as a quickly calculated proxy for capital strength. With ratios ranging from 5.4% at J.P. Morgan to 6.49% at Citigroup, all four of the large banks exceed the 5% minimums that seem to be the current benchmark in the markets. We expect each bank will want to have some cushion on top of this minimum--but how much depends on the bank's risk-mix and comfort level.

Profitability under New Capital Standards
Based on all the various metrics discussed, it is obvious that the Big Four U.S. banks are going to have to carry more capital than in pre-crisis times. A quick look at historical ROEs and capital ratios suggest long-term returns are going to be affected. However, the news is not all bad. A higher equity level is likely to be offset by several factors. First, banks are charging more for loans, which will increase the yield and, we would hope, their earnings. Second, higher equity levels means less interest on liabilities, which will increase the net interest margin and help the bottom line as well. Third, three of the four (Citi being the exception) have increased greatly in size during the crisis through acquisitions. Banking has significant economies of scale, which may help improve profitability.

All that said, we do expect that on average the banks' profitability will come down. The one exception is J.P. Morgan, which was burdened with restructuring and integration costs during the 2002-06 time period. The severity of the drop, however, greatly varies based on the individual company's situation. Citigroup is shrinking and losing earnings power while massively increasing the size of its equity. Bank of America's equity has also increased quite a bit, but most of its profitability will likely remain intact. We believe Wells Fargo will take only a small hit from the higher capital standards--as its historical standards were already way above its peers'.

With the exception of Citigroup, we expect each bank will be able to produce excess returns in the long run. Citigroup's long-run returns are subject to so much speculation--including what will happen with the government's stake, how much of Citi Holdings will be run down or sold off, and what the company's ultimate business will look like. The figures above reflect our base-case scenarios--in our upside scenario we believe Citi's leverage could equal Bank of America's and its profitability would improve to rival B of A's as well.

Jaime Peters does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.