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In judging banks’ capital adequacy, regulators rely on three capital ratios: Tier 1, Total Capital, and Leverage. Lately, though, a growing chorus of equity investors has emerged to argue that the most important capital ratio of all isn’t any of those, but rather their new favorite, Tangible Common Equity/Total Assets (or Risk-Weighted Assets).
I’ve explained here before why I think investors’ new obsession with TCE/TA is misguided: what matters is what regulators care about. They’re the ones who decide which banks live and which ones die. A ratio du jour that’s become trendy with investors is essentially beside the point.
But there’s another reason to object to TCE/TA. It can materially understate (or overstate) the health of a bank, since its calculation of common equity includes unrealized securities losses. In my view, unrealized losses (or gains) should not be included in the capital calculation because of their inherent volatility.
Take a look at the chart below and you’ll see what I mean. It shows how large an impact unrealized securities losses have had on the banking industry’s tangible assets since the beginning of last year. At their peak, at the end of 2008, unrealized securities losses reduced the industry’s TCE/TA ratio by a whopping 120 basis points, according to the Federal Reserve.
Since the end of last year, the industry’s unrealized loss fell by $22 billion in the first quarter, which added 29 basis points to the industry’s tangible equity ratio. If the TCE-philes had had their way, they would have clamored for banks to add capital at the worst, most expensive part of the cycle, only to see that new capital become redundant a few months later simply because the securities markets changed course. This is not a rational way to regulate the baking business.
Moral of story: Stop obsessing about the tangible common equity ratio. At best, it’s irrelevant; at worst, it’s distortive.
What do you think? Let me know! |