More on meaningless bank capital: Bragging banks keep mum on this number

In his Wall Street Journal Heard on the Street column, David Reilly exposes the vast gap between the banks' claim to 'fortress balance sheets' and the reality.

Regular readers know that bank capital is meaningless for several reasons.  As pointed out by the OECD, the level of bank capital is meaningless for several reasons including:

• Regulatory forbearance has allowed the banks to engage in 'extend and pretend' and turn losses on bad debt into 'zombie' loans; and
• Suspension of mark-to-market accounting has allowed the banks to engage in 'mark-to-mythology'.

Besides overstating book capital levels, the Basel-based bank capital ratios have their own reasons for being meaningless starting with

• Banks use their own internal models to value their securities.

In his column, Mr. Reilly looks at how banks brag about what a great meaningless bank capital ratio they have and remain silent on the tainted leverage ratios when the banks' risk adjustment of their assets is removed.

My fortress is stronger than yours. 

Ever since J.P. Morgan Chase started referring to its "fortress" balance sheet, other banking giants have sought to portray themselves in a similarly strong light. The latest front in this bragging battle has been estimates of Tier 1 common capital under new Basel III capital rules. 

As big banks roll out fourth-quarter results in the coming week, investors can expect to hear more chest-thumping on this front. Besides being the main gauge of bank strength, this ratio also will figure in the Federal Reserve's consideration of requests by big banks to return capital. 

Given that the gauge divides one meaningless number, bank book capital, by another meaningless number, bank risk adjusted assets, it is hard to imagine that the result is a meaningful number.

Regular readers will recall that the Basel capital ratios have always been about hiding the true amount of leverage that the banks are taking on (your humble blogger knows this having worked on the creation of Basel I).

The idea the banking industry sold their regulators on was that Basel I was needed so the banks could hide their use of leverage to generate a higher return on equity and this higher return on equity was needed to attract capital investment.

And why would the regulators have wanted the banks to attract capital?  Because in the 1980s, the large banks were insolvent (the book value of their liabilities exceeded the market value of their assets) because of the losses on their loans to Less Developed Countries.

Banks have been far quieter, though, about another important measure of their financial strength: leverage ratios under the new Basel rules. Those have received far less attention than the Tier 1 common ratio or new liquidity rules, which central banks recently eased. 

Yet given all the criticism of the Basel rules, in large part due to the emphasis many of its gauges place on risk-weighted measures of assets, the leverage ratio should be getting far more attention and disclosure. That is because it is based on total assets, not an adjusted measure of them. 

And the difference between the risk-weighted and unadjusted measure of assets can be telling. Risk-weighted assets were equal to just 67% of total assets at U.S. banks at the end of the third quarter, according to Federal Deposit Insurance Corp. data. That is down from about 75% before the crisis. 

The gap is even wider at the biggest banks. At the big four—J.P. Morgan, Bank of America, Citigroup and Wells Fargo —risk-weighted assets averaged 60% of total assets at the end of the third quarter. 

The lower risk-weighted assets are, the higher capital ratios appear, meaning banks need to hold less equity. Moreover, calculations of risk-weighted assets are in many cases dependent on models devised by banks themselves. 

One of the reasons that your humble blogger has been advocating that banks be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is that market participants can use this information to independently "calculate" capital ratios for the banks.

Market participants can see and make adjustments for losses hidden by 'zombie' loans and the suspension of mark-to-market accounting.  Furthermore, market participants can assign values to those illiquid securities sitting on bank balance sheets.

The result of these adjustments is a capital measure that market participants can trust.

Granted, this year investors might start to get a glimpse of what leverage ratios look like under the new Basel rules, but not in the U.S. 

Banks in the U.K., for example, are supposed to begin disclosing these as they report final 2012 results. In its November Financial Stability Report, the Bank of England said this will "represent an important first step in helping to reduce investors' uncertainty about firms' resilience, given market concerns about inconsistencies in risk-weighted asset calculations." 

Although European banks generally have far lower levels of risk-weighted assets to total assets, it is still too bad U.S. banks aren't being pressed by regulators to follow suit. None of the big U.S. banks so far have chosen to disclose estimates of their leverage ratios under the new Basel rules. 

Until banks do so, it will be easy for investors to assume they are playing coy because the figures might not be as flattering as their Tier 1 common ratios, which in most cases are now close to or have met minimum thresholds. That is especially the case because the biggest U.S. banks are likely to see their assets rise under the new Basel leverage-ratio rules. 

Unlike banks that report under international accounting rules, U.S. banks show the "net" value of their derivative assets and liabilities on the face of the balance sheet. Under the Basel leverage rules, though, some of these will be included in their assets. 

That will potentially make them look more levered. This could call into question claims about how thick their fortress walls actually are, even as they look to return "excess" capital to shareholders.... 

So, the sooner U.S. banks start showing this measure the better, given questions about the risk weighting of assets. 

With banks still trying to water down new regulations, it is easy for investors to forget that questions over bank capital, and just how thick it is, are far from resolved.

Investors should always assume that the bank capital ratios are meaningless, because until there is ultra transparency and the banks are forced to clean up their balance sheets, these ratios are meaningless.