BUS614: International Finance

Over the last 20 years, the financial sector has become larger, more complex, and more interconnected. While this expansion has facilitated the development of new financial products and markets, it has also introduced new risks to the financial system and the economy in general. The housing crisis and the subsequent collapse of the large investment banks Bear Stearns and Lehman Brothers and the government takeover of insurer AIG clearly demonstrates how negative events can easily ripple through the interconnected financial system and cause great harm to the banking system and the broader economy. Going forward, capital regulation will likely play an important role in adding stability to the financial system.

Bank capital is a measure that appears on the liability side of the bank's balance sheet. One way to think about it is that capital is what is left over when you subtract other bank liabilities (such as deposits and loans made to the bank) from bank assets. One regulatory measure of capital is tier I capital, which is defined as the sum of common equity, noncumulative perpetual preferred stock, and minority interest. Tier II capital includes preferred shares not included in tier I capital, hybrid capital, term subordinated debt, general loan-loss reserves, and unrealized gains on equity securities. While regulators view large levels of tier I capital as an essential buffer against unexpected losses, the more risky tier II capital is generally viewed as a supplemental buffer.

FDIC-insured institutions fall under two regulatory capital requirements, the leverage-ratio and risk-based-capital requirements. Under the leverage ratio requirement, the FDIC requires banks to maintain a ratio of tier I capital to tangible assets of 4.0 percent. It is important to use tangible assets since this measure excludes intangible assets, such as goodwill, which cannot be easily valued upon liquidation.

In addition to the leverage ratio, banks are also required to maintain certain levels of tier I and tier II capital relative to risk-weighted assets. Risk-weighted assets allow banks to hold different levels of capital for various assets based on those particular assets' credit risk characteristic. Moreover, unlike the leverage ratio, risk-weighted assets also consider assets that banks take off their balance sheet, such as the unused portion of a line of credit. Two ratios are important: a tier I risk-based capital ratio, which is tier I capital divided by risk-weighted assets, and a total risk-based capital ratio, which is the sum of tier I capital and tier II capital divided by total risk-weighted assets.

In order for a bank to be considered well capitalized in the United States, it must have a leverage ratio of 5.0 percent; a tier I risk-based capital ratio of 6.0 percent; and a total risk-based capital ratio of at least 10.0 percent. (Banks or bank holding companies with a rating of "1" need a leverage ratio of only 3.0 percent.) Conversely, a bank is considered undercapitalized if its leverage ratio or total risk-based-capital ratio falls below 4.0 percent or 6.0 percent, respectively.

Based on these measures of bank capitalization, the U.S banking industry has been well capitalized over the past decade. From March 2001 to December 2011, the average tier I capital ratio for the four largest bank holding companies rested above the well-capitalized threshold of 5.0 percent, averaging 6.4 percent from 2001 to 2011. Moreover, the average tier I leverage ratio for banks deemed systemically important (assets greater than $50 billion) was higher than the four largest bank holding companies, averaging 7.4 percent over the same period.

Additionally, bank holding companies were considered well capitalized under the broader measure of total capital. From 2001 to 2011, the four largest bank holding companies posted an average capital ratio of 12.8 percent, firmly above the well capitalized threshold of 10.0 percent. Systemically important bank holding companies managed to stay above the well capitalized threshold with a slightly lower average total capital to risk-weighted-assets ratio of 12.2 percent.

It is important to note that in response to the financial crisis, banks began to increase their levels of capital to serve as a buffer against potential losses. From September 2008 to December 2011, the average tier I leverage ratio of all bank holding companies increased 190 basis points from 8.9 percent to 10.8 percent, and the average total capital ratio increased 430 basis point, from 12.9 percent to 17.2 percent.

The improvement in the tier I leverage ratio and the total capital leverage ratio can be attributed to an increase in both in tier I capital and a leveling off of risk-weighted assets. In response to the financial crisis of 2008, bank holding companies increased their tier I capital by 54.6 percent, from $790 billion in September 2008 to $1.2 trillion in December 2011. Meanwhile, over the same period, total risk-weighted assets rose only 16.5 percent. The combination of rising capital levels and falling risk-weighted assets resulted in better capitalized banks.

Total Capital

Source: Federal Reserve Bank of Cleveland, https://www.clevelandfed.org/newsroom-and-events/publications/economic-trends/2012-economic-trends/et-20120501-bank-capitalization.aspx
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