April 30 (Bloomberg) -- Some of the world’s largest banks are announcing spring makeovers. Earnings have improved, expenses are lower and capital ratios are higher. Today, for example, Deutsche Bank AG said its first-quarter earnings rose 19 percent and that it had sold almost 3 billion euros ($4 billion) of new stock.
Deutsche Bank had been one of the most undercapitalized of the large, global banks. It now says it’s ahead of schedule -- and its peer group -- in meeting new capital rules that international regulators agreed would take full effect in 2019.
Warning: The big banks may be in compliance, but that doesn’t mean they are safe or no longer too big to fail.
Justifying this statement requires a brief explanation of capital. By capital, we mean money that comes from shareholders when they buy stock, also known as common equity. Capital is also the money that comes from earnings if banks retain those funds, rather than distribute them as dividends.
Banks are required to have capital because it can absorb losses. Problem is, most big banks have very little capital; instead, they borrow to obtain the bulk of their money. Creditors think governments will bail out megabanks if disaster strikes, as in 2008. Because of this, such banks can borrow at lower interest rates than they otherwise would, a competitive advantage as well as a taxpayer subsidy. It’s therefore understandable that most big banks prefer to borrow money than sell shares or retain earnings to fund operations.
It’s also important to state what capital isn’t. It isn’t money a bank “holds” or “sets aside” to satisfy new regulations. A dollar of capital isn’t one less dollar working in the economy. Capital isn’t a rainy-day fund or a basket into which banks place excess cash in case the economy falters. Nor is capital the same as loan-loss reserves, which is money banks must set aside in the expectation that certain loans won’t be repaid.
Banks, moreover, can use capital the same way they use borrowed money -- to make loans, invest, trade securities and pay expenses. They can lend it to startup companies or big businesses. The banking industry allows lawmakers, the news media and others to characterize capital as a reserve because it suits their line of defense -- that having more capital would result in fewer loans and hurt the economy.
Under the latest regulatory pact, called Basel III, large global banks’ safest capital, called core Tier 1, must equal 7.5 percent of assets and be predominantly common equity and retained earnings. The catch is that banks are allowed to weight their assets (such as loans to companies and individuals, and securities and office buildings) according to the level of risk they represent. A loan to a government, for example, is considered less risky than a loan to a startup company.
The process of risk-weighting has become vexed. Most banks rely on credit ratings combined with internal mathematical models that try to predict risk levels, based on past performance. As we learned from the recent crisis, mortgage-backed securities were considered low-risk, carried the highest credit ratings and didn’t require capital.
This brings us back to Deutsche Bank, which today reported that its core Tier 1 capital ratio is 8.8 percent of risk-weighted assets.
Impressive. But there’s a catch. Deutsche Bank gets to that number with aggressive use of risk-weighting to reduce its assets from 2 trillion euros -- about 56 percent of Germany’s total economic output -- to about 325 billion euros, an 84 percent shrinkage. By comparison, the risk-weighted assets of the world’s largest financial companies equal about 50 percent of their total assets.
To Deutsche Bank’s credit, it just raised almost 3 billion euros in fresh Tier 1 capital by selling shares. This will bring its core Tier 1 ratio to 9.5 percent, from 8.8 percent. Still, Deutsche Bank’s risk-weighted assets will remain tiny when compared with its total assets, as will its capital.
Luckily, there is a better way to judge financial health, called a leverage ratio, which is similar to a capital ratio without the risk weighting. Deutsche Bank’s leverage ratio as of last year’s third quarter was 1.47 percent, the lowest among 28 large global banks, according to calculations by Thomas Hoenig, the vice chairman of the U.S. Federal Deposit Insurance Corp.
That means a decline of 1.47 percent in the value of Deutsche Bank’s assets could have left it insolvent. The average leverage ratio at large U.S. banks, including JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp., is 3.88 percent (using international accounting rules) as of the fourth quarter of 2012. Better, yet still too low. All comply with Basel III’s 3 percent minimum leverage ratio, but even then, debt would be funding 97 percent of assets.
The FDIC’s Hoenig said in an April 9 speech that risk weighting gives the “illusion of strength even when a firm incurs losses.” Deutsche Bank, for example, had a net loss of 2.54 billion euros in last year’s fourth quarter. But its capital ratio actually improved after regulators allowed it to decrease risk-weighted assets by selling investments, adding hedges and adopting what the bank calls “more advanced risk models.”
A system that is so malleable is discomfiting. To avoid this, a growing number of economists recommend that banks have 20 percent equity, without any risk weighting. We agree. Such a requirement wouldn’t harm economies. Far from it: The history of financial crises shows that the greatest damage to economic growth happens when banks become distressed from having borrowed too much.
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