The Magic of Vanishing Bank Capital

A recent study by Scott Strah, Jennifer Hynes and Sanders Shaffer at the Federal Reserve Bank of Boston looks back at the financial crisis of 2008 - 2009 and examines how hard the crisis hit the capital position of major United States financial institutions.

The banking system requires a level of capital that is sufficient to preserve its stability.  Without this capital, the system will implode, something that very nearly came to pass during the crisis of 2008.  For those of my readers that are only vaguely familiar with the concept of bank capital, it is defined as "the difference between the value of a bank's assets and its liabilities.".  A bank's capital is basically the buffer of both cash and safe assets that banks possess and can access to protect creditors in case the bank's assets are liquidated.  In most cases, these funds are a mixture of equity (common and preferred shares) and debt that banks hold to support their ongoing business and to support the risks involved in the banking sector (and, as we all saw in 2008, there are plenty of risks in banking!).  You will often see the term "tier one capital"; this refers to the bank's most secure capital and this capital cannot be redeemed at the option of the holder (i.e. the shareholder in the case of equity) with core tier one capital being a subset of capital that is the most secure capital.  Banking system capital is measured against the value of the risky assets that a given bank holds.  Under the new Basel III rules, banks must have  a minimum ratio of 7 percent core tier one capital on its risk-weighted assets (i.e. its loan portfolio), up from a measly 2.5 percent under Basel II.  The phase-in period for the new enhanced capital rules will occur over several years with the entire implementation taking place in 2019.  In case you are interested, here is a link to an interesting video that explains Basel III in its entirety:

BASEL3 ENG 2013 from MultiMediaStudioBrussels on Vimeo.

Now, let's go back to the Fed's analysis of what happened to the banking system during the latest financial crisis and look at how quickly America's largest financial institutions saw their capital ratios decline or completely disappear.  The authors examined 26 financial institutions including domestic banks (bank holding companies or BHCs), domestic thrifts and domestic broker-dealers with total assets in excess of $100 billion.

Here is a chart showing the findings of this study noting that the figures in red represent the maximum erosion of both Tier I capital and common equity over the period from the first quarter of 2007 to the second quarter of 2012:

A total of eight institutions (31 percent of the total) had Tier I Common Capital ratio erosion levels of 450 basis points or more, twelve institutions had capital erosion levels in excess of 300 basis points and 13 institutions (half of the total) had capital erosion levels in excess of 200 basis points.  Of the banks that had capital erosion levels in excess of 5 percent, there were four that had erosion of more than 7 percent including National City Corp, Merrill Lynch, Countrywide Financial and Washington Mutual.  What is even more stunning is that six of the seven banks that were acquired by other banks during the crisis had four or fewer quarters of capital depletion before they failed.  In the case of Lehman Brothers and Bear Stearns, they had just two quarters of capital depletion before Lehman failed and Bear Stearns was acquired by JPMorgan Chase.  In the case of Lehman, the authors' calculations do not show the entirety of the capital depletion problem since it failed so rapidly.

What is even more frightening is that, without massive government intervention, the losses could have been far worse had the Washington and the Fed not stepped in to backstop the losses.  We might not be so lucky during the next crisis given that the federal debt level is now just over 81 percent higher than it was at the beginning of 2008 making it difficult for Washington to intervene.  Without the intervention of Washington in 2008 and 2009, many of America's banks would have found themselves in far worse shape, particularly since with Washington's assistance, they were able to push their credit-related losses further into the future when the banking system once again became profitable.  

As we can see from this study, the proposed capital increases under Basel III will provide some protection for the banking system, however, as you can see from the chart above, even a 7 percent capital ratio can be depleted very, very easily and very, very quickly.  Despite what we are being led to believe, our current banking system is still very fragile even under the new and supposedly improved, stiffer regulatory environment.