Banks' Capital Cushions: Thicker, But Still Not Comfy

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 securities to 15 percent of total assets from 11 percent, with JPMorgan Chase’s rising to 18 percent from 7 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.

Comments

[User 368280:]

Since when did TCE become the only measure....it came in vogue 9 mos ago...prior the focus was appropriately on the tier 1 capital ratio. TCE gives no credit for non redeemable non cumulative preferred...a hyper conservative measure dreamed up by a political persuasion. All of this without adequate adjustments for huge trading books like JP Morgan and huge SPE risk

Oct 31 10:06 AM

[KirbyJF1:]

A better solution would be to re impose the Glass-Seigel regulations separating commercial Banks from the Thugs ((Wall Street)). Also impose much stricter regulations on derivatives & treat them as insurance with adequate reserve positions.

Kirby

Oct 31 01:59 PM