Saturday, May 9, 2009

There is no “correct” capital ratio for a bank – save for the need to have enough when things go bad

TO BE NOTED: From the FT:

Stress test jargon explained

By Stuart Kirk and Francesco Guerrera

Published: May 7 2009 18:16 | Last updated: May 7 2009 19:10

What is the US Treasury’s preferred metric in its stress tests?

The Treasury is emphasising tangible common equity, or TCE, which is considered to be the purest and most conservative measure of a bank’s financial health. It gives a picture of a bank’s liquidation value – since it is calculated by taking shareholders’ equity, and then subtracting goodwill, intangible assets and preferred shares.

What makes tangible common equity (TCE) so accurate?

TCE has the advantage of not counting preferred shares – a hybrid of debt and equity that would be of little value if a bank had to liquidate. Goodwill and intangibles are also excluded from the measure because they become worthless if a bank goes under.

What are risk-weighted assets (RWA)?

To judge a bank’s capital needs in the stress tests, the Treasury compared TCE with risk-weighted assets. Rather than treating all assets on the balance sheet equally, different asset classes are given weightings according to their perceived riskiness.

This process enables banks to hold less capital against assets considered less risky while setting aside more reserves for riskier assets. For example, corporate loans are 100 per cent risky, whereas US government bonds are given no risk weighting at all.

If many US banks have to convert preferred shares into common equity, what will happen to common shareholders and preferred shareholders?

Preferred or preference shares usually rank above common shares in the capital structure, but still behind debt holders. Preferred shares tend not to have voting rights, but holders receive a negotiated dividend that must be paid ahead of dividends to common shareholders.

If preferred investors decide to convert their holdings into common equity, they will lose their right to the preferred dividend as well as their seniority in the capital structure.

Common shareholders, on the other hand, will suffer a reduction or “dilution” in the value of the shares as the conversion of preferred shares will increase the total share count.

Why has the Treasury decided that a TCE/RWA ratio of at least 4 per cent by 2010 is adequate?

There is no “correct” capital ratio for a bank – save for the need to have enough when things go bad – nor is there an agreed way to calculate it. Before the credit crunch, banks could operate with very low capital ratios (indeed, the lower the better, because low ratios, or higher leverage, freed up capital and boosted returns). Today investors (and regulators) are insisting they have more, although the number is arbitrary.

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