General Review of Capital Ratio Framework:
For those that need a refresher on bank capital or new to the subject, banks generally need to keep a stack of capital to absorb losses when some assets go sour. The banking model is designed in a way that leverage is needed to boost returns. With return on assets averaging only about 1%, a financial leverage ratio (total assets to total equity) of let's say 20X is needed to achieve the rich 20% ROE reported by most banks.
During the 2008 financial meltdown, many banks found themselves in trouble as many of their assets (mostly in securitized mortgages or other structured finance instruments) went sour. After the crisis, new capital rules called "Basel III" was implemented to prevent bank failures. Under Basel III, banks need to meet certain capital ratios calculated using a risk-based framework. These ratios are calculated using a capital number in the numerator and the risk-weighted assets (RWA) as the denominator.
RWA is a total asset number based on sum of assets multiples by their risk weights. This calculation is done usually by the bank itself and could be subjective given different banks can use different risk weights on the same assets (see below)
Here some definition of capital under Basel III (for those who wants a quick review):
Tier 1 common: Capital in forms of common shares, retained earnings. This is the most reliable source of capital
Tier 1 capital: Tier 1 common with addition of preferred shares
Tier 2 capital: Subordinated debentures and certain loan loss allowances
Total capital: Tier 1 + Tier 2 capital
As of July 2013, Canadian banks are already reporting capital ratios under Basel III while U.S. regulators are working to implement Basel III according to the phase-in schedule set out by the Basel committee. For all banks under Basel III, banks are required to hold a Tier 1 common equaling or greater than 7% of RWA. Canadian banks are required to hold 8% or greater due to a new rule by OSFI (Canada's financial regulator)
The problem with the risk-based approach is that Basel regulations allows banks to use their own internal risk models to evaluate the risk weights. This approach is often called the Internal Ratings Based (IRB) or advanced-IRB (A-IRB). A recent study by BIS committee illustrates how risk-weights to account credit risks in their banking books differ materially. See BIS study on the significant differences in risk-weights in bank's book (http://www.bis.org/publ/bcbs256.htm). Fun fact: There is a reason that European banks lack capital, their risk weights applied in their banking book is too lax.
New Leverage Ratio:
As many regulators found out, banks can cheat a little when they calculate their capital ratios because of the loopholes in the IRB or A-IRB approaches to calculate risk-weights and thus impact the calculation of risk-weighted assets (RWA). Given capital ratio (such as Tier 1, or Tier 1 common) is using RWA as the denominator, a lower RWA will make a bank appear more healthier than it is. A new proposal under Basel III is use of a leverage ratio as a supplementary capital ratio. This leverage ratio is calculated as a capital number in the numerator and a "total exposure" number in the denominator. This new leverage ratio will take account banks' leverage which include off balance sheet numbers in the calculations. Notice that the leverage ratio is less subjectively calculated compared to risk-based capital ratios although the total exposure number could be subject to some ambiguities.
The capital number currently proposed is the Tier 1 capital. The total exposure number is a sum of on balance sheet items (adjusted for secure financing transactions and derivatives) and off-balance sheet items. Off balance sheet items include: commitments (include liquidity facilities), unconditionally cancellable commitments, standby letters of credit, trade letters of credit, unsettled securities etc. For those interested to learn more on the calculation, see the link below on the Basel committee's leverage ratio proposal.
The Basel committee's plan is to have banks report leverage ratio by January 2015 and have banks meet a minimum leverage ratio requirement of 3% by January 2018.
U.S. Banks Leverage Ratio (Sources: Company Reports)
Wells Fargo: >5%
Bank of America: between 4.9% and 5%
Morgan Stanley: 4.2%
JP Morgan: 4.7%
Goldman Sachs: Not given
During the Q2 U.S. bank reporting session, many banks reported consolidated leverage ratios. This is due to a new proposal from U.S. regulators that U.S. banks must meet a 5% leverage ratio at the bank holding level and 6% for each banking subsidiaries. Given most U.S. large banks are quite close in meeting these new tough rules, it shows how much U.S. banks have improved since the financial crisis. Most U.S. banks are still trading near book value compared to Canadian banks that are still trading at 2X book.
A report by CIBC World Markets puts the average big six (RY,TD,BNS, BMO,CM, NA) bank's leverage ratio at ~3.5% vs. the near 5% for most average U.S. banks. For Canadian bank investors, don't feel alarmed. This is because of the different business mix and the fact Canadian banks hold insured mortgages (essentially risk free because guaranteed by CMHC which is a government entity) while U.S. banks usually securitize or sell their mortgages off.
Capital is very important for bank. Basel III raised the capital requirement to 7% of tier 1 common (old rules were so lax that banks needed only 4% of tier 1 capital) and introduced various new measures such as the leverage ratio as discussed above. I find the new liquidity ratios introduced through Basel III such as the stable funding and liquidity coverage ratios will further assist investors in evaluating bank's solvency and liquidity. The downside to investors is the need to understand these new complex rules and they will impact banks' operations. Banks are profitable businesses but they are also very complex businesses for investors to understand.
Similar to Warren Buffett's opinion on GAAP accounting rules, I have a similar sentiment towards Basel III. I find Basel III far from being perfect, but would hate to be the one tasked to find a better alternative method.
Basel III capital: http://www.bis.org/publ/bcbs189.htm
OSFI Capital Requirement: http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=5050
Leverage Ratio Proposal: http://www.bis.org/publ/bcbs251.pdf