Tangible Common Equity: How Much Is Enough?

Includes: BAC, C, JPM
by: Mark Sunshine

Suddenly, everyone is interested in the amount of tangible common equity (”TCE”) invested in banks. Oddly, no one seems to know how much TCE is enough, despite TCE being the primary and most important element in determining the adequacy of bank capitalization. Of course, history provides a guide to what is enough TCE - and right now banks don’t have enough. Only a massive amount of public and private bank investment will fill in the existing capital hole, which explains the falling stock prices of many banks and financial institutions.

What is “tangible common equity” and how is it measured?

Banking regulators started focusing on the low level of TCE at large banks right after Tim Geithner became Treasury Secretary. Adequacy of TCE is measured by the TCE ratio, which is the amount of TCE divided by amount of tangible assets. Banks with higher TCE ratios are better capitalized and have a lower risk of failure than banks with lower ratios.

TCE is different than common equity because TCE is reduced by the amount of intangible assets owned by a bank. Intangible assets are things like goodwill and tax benefits from net operating loss carry forwards. These assets don’t produce income and don’t have a cash equivalent value. Moreover, intangible assets can’t support banking operations or cover losses. Even worse, intangible assets have a childlike “pretend” quality to them; one minute everyone pretends intangible assets are there and then the next minute reality sets in and they disappear.

Regulators focus on “common equity,” and not all forms of capital because only common equity can be depended upon in a tough pinch. Other forms of capital are “Almost Common Equity” and include preferred stock and subordinated debt. Almost Common Equity investors are fair weather friends; they are just like best friends when things are good but when things don’t go well they stop pretending. Preferred stock and subordinated debt investors think that they are going to get paid back and earn a fixed yield through interest and dividend payments and eventual repayment of principal. When things aren’t going well most Almost Common Equity investors turn into creditors and demand their cash back. Only common stockholders expect to stick it out through thick and thin.

How much is enough? The 1980s experience

Since Geithner mentioned the stress test, media pundits have been arguing about how much TCE is enough. Many “experts” say that a 4% or 5% TCE ratio is good enough. Well…I don’t think so.

When I was a young lawyer in the early 1980s, I remember S&L CEOs telling me that a 4% to 5% TCE ratio was good enough for them. Within a few years every CEO who said that 20 to 1 leverage was a good idea (that is what 5% TCE ratio means) had been ejected from the industry and their institution seized. Some of those CEOs were in jail.

More recent data on TCE from 1995

But the 1980s was a tough time in American finance and was a long time ago. After all, it was before the internet, derivative securities and securitization. To today’s young Turks, 1984 is ancient economic history and before some people working on Wall Street and in banking were born. So, maybe my memory of ancient history needs to be updated with a more current example of adequate levels of TCE for safe and sound banking operations.

I think the amount of TCE that banks had in the mid-1990s is a benchmark that current market participants can identify with and accept. After all, by 1995 the internet had been invented, most of the Republican leaders who are in the news today were in the news then, and securitization was an accepted form of financing.

Below is a chart comparing the amount of TCE that a select group of banks had at the end of 2008 and at the end of 1995. The reason I selected the below banks is because I was able to talk a friend at an investment bank to pull the information for me and this is what he found (thanks Brent!). The sample isn’t random and lacks the sampling purity of an academic exercise. But I know enough about statistics to know that the uniformity of the results make it statistically significant and important.

Tangible Common Equity / Tangible Assets (%)




Bank of America Corporation



Bank of New York Mellon Corporation



BB&T Corporation



Citigroup Inc.



JPMorgan Chase & Co.



PNC Financial Services Group, Inc.



State Street Corporation



U.S. Bancorp



Wells Fargo & Company






Source: SNL Financial
PNC Financial Services Group is as of 9/30/08
Citigroup, Inc was CITICORP in 1995
Click to enlarge

So, how much TCE is enough?

It’s a lot more than the banks currently have and probably more than in 1995. Banks need more TCE today because they are riskier companies now than they were 13 years ago. Off balance sheet liabilities, credit default swaps and stupid decisions of the last 8 years didn’t exist in 1995 and need TCE. The capital hole in the banking system to restore TCE levels to those that existed in 1995 is in the hundreds of billions and even more is required to cover the new liabilities of today’s banking system.

Sophisticated investors understand the magnitude of the capital hole and know that this problem is causing bank stocks to tank. And, sophisticated investors also understand that until large banks get their house in order, corporate earnings will be anemic (at best). The reason the stock market has been diving isn’t because of Obama’s budget proposals, it is because his administration is shining a bright light on bank capital ratios and their capital inadequacy.

It took years of neglect for bank capital ratios to drop as far as they did and it will take several years for banks to repair their balance sheets. Obama didn’t make this problem, but we are lucky that his administration is trying to figure out how to fix it.