Banks Are Still Unable to Assess Competitors' Solvency

The key concern for markets and regulators was that they weren't sure they understood the extent of toxic assets on the balance sheets of financial institutions - so they couldn't be sure which banks were really solvent.  [Financial Crisis Inquiry Commission Report summary of the role of contagion in the credit crisis, page 373 pdf]

The ability to assess the risk and solvency of the large, global financial institutions has still not been addressed.

Until banks are required to disclose current asset-level data so competitors can actually do their own analysis to determine a bank's risk and solvency, competitors are forced to rely on one-off solutions like risk-adjusted capital ratios.

A column in the Wall Street Journal highlights the problem with relying on risk-adjusted capital ratios that are not being consistently calculated across the too big to fail.

Bank strength still is very much in the eye of the beholder. 

... firms can rely on differing definitions of Tier 1 capital, a key measure of bank strength. 

That debate comes as worries rise in the U.S. that varying approaches in the calculation of Tier 1 ratios will put big American institutions at a competitive disadvantage to European rivals. 

Risk weightings of assets measure the threat of loss posed by different holdings. So, a government bond will receive a lower risk weighting than a "junk" bond. A lower risk weighting for a bank's total assets may allow it to hold less capital. That can help boost returns and profit. 

J.P. Morgan Chase CEO James Dimon recently fired a broadside over that issue. He questioned differences in models other banks use to calculate risk-weighted assets that help determine Tier 1 ratios. 

A comparison of J.P. Morgan's risk-weighted assets to peers suggests their approach "can't be accurate," Mr. Dimon said at his bank's investor-day conference last month. "I mean, obviously, someone's using far more aggressive models." Although Mr. Dimon didn't single out particular institutions, it appears he was pointing a finger at Europe. 

Determining risk weightings relies on complex calculations and judgments. In the U.S., banks calculate them based on an older, restrictive version of international capital standards. European banks use an updated version allowing wider discretion through management's use of internally devised risk models. 

... But the danger mightn't be so much that U.S. banks face competitive constraints as it is that European banks, by using higher leverage, or borrowed money, are courting greater risk. 

For investors, the answer is to cast a skeptical eye on regulatory measures of bank strength.