Bank Regulatory Capital Requirements

Not All Capital Ratios Are Equally Informative

Actual Capital Ratios Compared to Required Minimum Capital Ratios

A number of recent academic studies suggest that a simple equity to asset leverage ratio equal to roughly 15 percent would have benefits that are associated with reducing the effects of financial stability that equal or exceed costs associated with implementing the regulation. On the other hand, nearly all the capital adequacy guidelines set by BCBS are based on a bank's risk-weighted assets. In this section, we provide evidence that the various capital ratios imposed on banks are not equally informative about whether a bank is adequately capitalized.

The analysis proceeds by comparing the actual capital ratios to the required minimum capital ratios for some of the largest banks in the United States for every year over the period 2000–2017Q3. There are four such capital ratio comparisons: (1) the actual risk-based Tier 1 capital ratio is compared to the required minimum ratio of 4 percent from 2000 to 2012, 4.5 percent in 2013, 5.5 percent in 2014, and 6 percent in 2015 to 2017; (2) the actual risk-based total capital ratio is compared to the required minimum ratio of 8 percent; (3) the actual non-risk-based leverage ratio is compared to the minimum required ratio of 4 percent; and, (4) the actual non-risk-based tangible common equity ratio is compared to a (hypothetical) required minimum tangible common equity ratio of 4 percent. We also provide two other ratios that furnish an additional perspective on the four ratios just mentioned. These are the ratio of RWAs to total assets and the ratio of market capitalization to tangible common equity. The lower the former ratio, the less risk-based capital required, and in the latter case, a ratio greater than 1 indicates the market values a bank more than the book values indicate. Information is also provided about the averages and standard deviations for the different variables included in each of the tables as well as information about the number of banks with capital deficiencies or market-to-book values less than 1.

The calculations are made for six of the eight GSIBs and twelve other large banks with total assets greater than $50 billion, with the banks in every Appendix table ranked by asset size. Table A1 in the Appendix A shows the percentage by which the actual risk-weighted Tier 1 capital ratio exceeds the required minimum Tier 1 capital ratios for the eighteen banks from 2000 to the third quarter of 2017. All of the percentages are positive, which means that all the banks had capital buffers, or actual capital ratios, that exceeded the required minimum ratios. It is noteworthy that every bank's minimum capital buffer occurs in 2007 or earlier, while the maximum ratio occurs in 2009 or later. For nine of the eighteen banks, the minimum capital buffer occurs in 2007, which was in the midst of the banking crisis and the year before the bailout of the largest banks. Small banks were also bailed out, mainly in 2009. On the eve of the bailout, these banks more than satisfied their required minimum capital ratios. By 2015, moreover, all of the banks had more than met the new and higher capital requirement of 8.5 percent – 6 percent plus the capital conservation buffer of 2.5 percent – applicable beginning in 2019.

The situation is quite similar for the risk-weighted total capital ratio, as shown in Table A2 in the Appendix A. For every bank, the actual ratio exceeds the required minimum ratio, and by more than a trivial percentage, in each year. Importantly, just as in the case of Tier 1 capital, every bank had a positive capital buffer during 2007–2008, even though the United States was suffering the worst financial crisis since the Great Depression and it was in the midst of a severe recession. By 2015, moreover, all of the banks had sufficient capital to satisfy the minimum total capital ratio plus the capital conservation buffer of 10.5 percent.

To better understand how these banks' capital positions were changing over time, it is useful to look at the ratio of RWAs to total assets. Table A3 in the Appendix A presents this ratio in percentage terms for the eighteen banks for the years 2000–2017. Risk weighting makes it easier to exceed minimum capital ratios by lowering the total assets against which capital requirements are applied. The vast majority of the percentages in Table A3 are less than 100 percent because of the type of assets the banks have chosen to hold. After the risk-weighting formula is applied, almost all the banks' asset totals are less than the actual amount of assets. For example, for Citigroup, the ratio was 72 percent in 2000, and then trended downwards to a low of 51 percent in both 2008 and 2010. In the following two years, the ratio barely increased to 52 percent before increasing thereafter. In the two years when the ratio of risk-weighted assets to total assets was 51 percent, Citigroup did not need to have capital to back 49 percent of its assets. The decline in RWAs relative to total assets enabled the Tier 1 and total capital ratios to be higher with the same amount of capital then otherwise.

Table A4 in the Appendix A shows the actual non-risk-based leverage ratio minus the required minimum leverage ratio. All the capital buffers are positive. However, in contrast to Table A1 and Table A2, the percentages for most of the banks' capital buffers are smaller. In particular, the three largest banks had the smallest capital buffers in any year over the entire period, with the exception of BNY Mellon, State Street, and BB&T. In 2007, the figures were 2.00 percent for JPMorgan Chase, 1.04 percent for Bank of America, and 0.03 percent for Citigroup.

Another non-risk-based capital ratio is the tangible common equity ratio. Table A5 in the Appendix A shows the actual tangible common equity ratio minus a (hypothetical) required minimum tangible common equity ratio of 4 percent. This particular ratio, in which the numerator is based on the actual owner-contributed common equity less the actual intangible assets of a bank, is tangible common equity divided by tangible assets. The benefits of this measure lie in the fact that (1) it is less susceptible to guesswork or questionable manipulation, (2) market participants paid more attention to it than to other measures during the recent banking crisis, and (3) it is highly correlated to a market-value measure of capital. Regarding the latter point, based on the data for the banks in the Appendix tables, the correlation coefficient between tangible common equity capital and the market value of capital is 0.84 and it is highly statistically significant. Unlike Table A1, Table A2, Table A3 and Table A4, Table A5 contains quite a few negative percentages, as denoted by the cells with numerical values in parentheses. Moreover, in 2008, if tangible common equity had been the required capital measure for the minimum leverage ratio, nine banks would not have had enough capital to meet this minimum ratio. In 2007, one year before the bank bailout, neither Bank of America nor Citigroup would have met such a ratio. All of these banks received capital injections from the federal government. Importantly, according to Demirguc-Kunt et al., it is found that "the relationship between stock returns and capital is stronger when capital is measured by the leverage ratio rather than the risk-adjusted capital ratio … [and] higher quality forms of capital, such as … tangible common equity, [was] more relevant". In addition, Haldane points out that in terms of "pre-crisis predictive power … [m]easures of risk-weighted capital are statistically insignificant, while the leverage ratio is significant at the 1% level". He adds that "[u]sing different methods and samples, other studies support the predictive superiority, or at least equivalence, of leverage over capital ratios.

Table A6 in the Appendix A presents the market capitalization to actual tangible common equity ratios for the eighteen banks. A ratio greater than 1 means the market value of a bank is greater than indicated by its book value. The table shows that every bank had a ratio greater than 1 in every year from 2000 to 2006. In 2008 and 2009, during the midst of the banking crisis, nine banks had ratios less than 1. The three largest banks had ratios less than 1 in 2008, while two of these banks also have ratios less than 1 in 2009. In the latter year, JPMorgan had a ratio of 1.04. During the period 2009 to 2017, only six banks had ratios that were greater than 1 every year, and those same banks also had ratios greater than 1 throughout the entire period from 2000 to 2017. Moreover, three of the banks – Bank of America, Citigroup, and Regions – had ratios less than 1 every year from 2008 to 2015.

As noted earlier, the data regarding capital ratios clearly indicate that whether banks have too little or excess capital depends on the specific capital ratio on which one focuses and whether the capital ratio is risk-based or not. Some of the ratios may indicate that a bank has sufficient capital to satisfy regulatory requirements, whereas other ratios may indicate that there is a deficiency in capital. This means that a higher regulatory capital ratio being imposed on banks may or may not affect bank behavior. To determine the outcome, one must know the specific ratio that regulators choose to increase. Importantly, in the aggregate, the market reveals that all ratios are not equally revealing about a bank's actual capital adequacy, as market participants pay more attention to some ratios than others when assessing whether a bank is adequately capitalized. Indeed, according to Graeme Wearden of The Guardian, the tangible common equity ratio … takes a more conservative view than other measures, such as Tier 1 capital ratios, and has become an increasingly important way of assessing the banking sector as the financial crisis … [in 2007–2008] deepened. Douglas J. Elliott, moreover, states that "[c]ommon stock investors, who have the lowest repayment priority, have focused intensely at times during the recent financial crisis on the most conservative measure, tangible common equity". He adds that "… investors recognize that they [intangible assets] are particularly difficult to turn into cash in a crisis and that they can lose value if a bank's overall franchise deteriorates. For this reason, many investors prefer to treat them as worthless when evaluating capital adequacy. Such investors focus on tangible common equity".