Those dangerous yet well-capitalized banks
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David Reilly has a good column today about bank health and capital ratios, honing in on the crucial fact that having a fair amount of capital is not in and of itself sufficient to reassure investors — or even the FDIC — that a bank is healthy. 96% of banks are well-capitalized, according to the FDIC, but 7% of banks are on its problem list, which means that there are dozens of at-risk banks which are also adequately capitalized.
That makes perfect sense to anybody who remembers Lehman Brothers or even Washington Mutual: if investors think that huge losses are coming around the corner, or that a bank is incapable of making sustainable profits over the long term, then no amount of capital today is likely to reassure them that a bank is safe. As Reilly explains:
Measures of capitalization are different from overall gauges of bank strength, known as Camels ratings. These ratings look at more than just bank capital. The acronym stands for capital, assets, management, earnings, liquidity and market sensitivity.
Camels ratings, which are secret, are supposed to reflect “the bank’s overall financial condition,” according to the FDIC’s Web site, and rank banks on a scale of 1 to 5. An institution rated 4 or 5 is placed on the FDIC problem list.
It is possible for a bank to technically be well- capitalized, yet receive poor-enough scores in other areas of its Camels rating to land on the problem bank list.
Camels ratings are, for good reason, kept highly confidential. But the point here is that they’re about more than just capitalization, despite the fact that the two can get elided: Reilly talks, a bit awkwardly, about “problem banks that are supposedly well-capitalized”.
In any case, stock-market investors don’t necessarily reward well-capitalized banks and punish those with only thin layers of equity — in fact the opposite is true much of the time. Even bond-market investors, who should know better, seem to be getting dragged back into the arena of complacence and moral hazard which proved so devastating last year.
There are lots of potential landmines which don’t show up in banks’ capitalization ratios. Reilly mentions modified mortgages; there’s also commercial real estate; quasi-sovereign emerging-market debt; and trillions of dollars in leveraged loans which have done very well of late but still look scary to anybody who’s been avoiding the Kool-Aid. And that’s just on the balance sheet: there can also be big problems in terms of the quality of management, or steadily-growing expenses on the income statement. On top of all that are liquidity issues: if a bank doesn’t have a large base of federally-guaranteed deposits, it’s always vulnerable to a run, no matter how much capital it has.
So while capitalization ratios are a more useful metric than, say, charities’ overhead ratios, there’s still a huge amount of information they ignore or obscure. Banks are complex entities, and can’t be boiled down to a single ratio. And if you think your bank is safe just because it has a capital ratio in double digits, it’s worth taking another look.