Rolfe Winkler

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The superstructure of financial reform may be stalled in Congress, but at least regulators are forcing banks to raise capital. Since the nadir of the financial crisis in the fourth quarter of 2008, the Big Four have more than doubled their common equity, raising another $55 billion just in the fourth quarter.

The question is whether they’ve raised enough. With capital only a bit above early ’08 levels, especially among regional banks, the answer is most likely no.

Stepping back for a minute, it’s helpful to remember why capital is so crucial. The most important reason is that it provides a buffer to absorb losses from the asset side of the balance sheet. As assets are written down, a too-thin equity capital cushion leads to a run among creditors who race to get out before taking a loss.  Bank runs — whether the run-of-the-mill type among depositors or the high finance equivalent among short-term creditors — can quickly bring a financial system to its knees.

Luckily, regulators appear to be laser-focused on capital. Documents published in December by the Basel Committee — an international collection of bank regulators — would redefine capital in a number of productive ways.

More stringent capital requirements are also a back door way to accomplish other regulatory goals. For instance, the “size” component of the recently proposed “Volcker Rules” is designed to limit reliance on non-deposit liabilities. The more capital banks are required to hold, the smaller these liabilities.

In a recent note to clients, Jason Goldberg of Barclays Capital said the Basel proposals will…

…present onerous requirements on banks, especially the capital and leverage ratio calculations. If this ratio were to be implemented, we believe that the impact would be substantial on those banks with large derivative books, as well as those who participate in the short-term funding markets and those banks who maintain large off balance sheet commitments…

To anyone other than a banker or bank shareholder, that all sounds fantastic. But celebrations would be premature. Some proposals could get watered down or thrown out, for one.

And while the definition of capital would change for the better, Basel has yet to outline what levels of capital will be required. (It may leave this to national regulators.) If required levels are set too low, banks will continue to be vulnerable to runs.

True, the asset side of the balance sheet doesn’t look as vulnerable as it did a year ago, what with many assets written down already. But banks still seem to be sitting on big losses.

Take, for instance, second-lien mortgages. The Big Four U.S. commercial banks carried $442 billion worth as of Q3 ’09. That’s about equal to their total tangible common equity.

Second-liens like home equity loans are subordinate to first mortgages, theoretically worthless if  the value of the home falls below the balance on the first mortgage.* With a huge chunk of U.S. real estate under water, the embedded losses here are huge.

So it’s good news that banks are raising capital, and that regulators are redefining it in a way that will make it more robust. But it’s too early to claim victory. Much more capital is needed before the financial system can stand on its own.

In a spot of good news for the economy, banks continued to rebuild their capital cushions in the third quarter. But are they doing so fast enough? One risk going forward may be the size of their securities portfolios, which could expose them to significant interest rate risk when the Federal Reserve finally taps on the brakes.

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Measured by tangible common equity, the biggest banks are levered 20 to 1, a solid improvement from last quarter’s 24 to 1 and a giant leap from 30 to 1 in the third quarter a year ago. (These figures exclude off-balance sheet assets, which will increase leverage when they are consolidated beginning next year).

Tangible common equity is the crucial measure of bank capital because it is the primary cushion banks have to absorb losses. When it gets too low, creditors panic and bank runs ensue. From a systemic risk perspective, it’s great that banks are rebuilding this cushion.

The crucial question is how they’ll fare in a less favorable monetary environment. While consumer prices show little sign of inflating, asset prices are another story. Interest rates near zero have encouraged investors to chase risky assets. If that trend continues, the Fed may have to unwind its balance sheet and raise rates sooner than it would like, putting banks in a tough position.

FBR Capital Markets points out in a recent note to clients that many banks have poured excess liquidity into their securities portfolios, “which could present significant interest rate risk” when the Fed reverses course.

Compared with last year, the top 10 commercial banks have increased the size of their securities portfolios nearly 40 percent, with JPMorgan Chase’s rising over 150 percent.

And while securities prices are more immediately sensitive to monetary policy, loan portfolios would be impacted as well. Early next year, after the Fed turns off its printing press and after the home-buyer tax credit expires, real estate prices could resume falling. This will put more owners upside down on their loans, keeping default rates high.

Banks are extending loans, pretending that asset prices will recover past peaks, an unlikely prospect if the Fed does its job.

Now it’s up to regulators to deliver higher capital requirements so that banks can withstand the end of government support. After all, 20 to 1 leverage is still very high. It only looks prudent against the insane levels reached last year.

It was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Yes, leverage is down, but only relative to the obscene levels reached a year ago.  Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.

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Tangible common equity remains the crucial measure of bank capital because it’s the primary cushion to absorb losses. When that cushion gets low, creditors panic. Bank runs ensue and the financial system ceases to function.

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