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BANKING AND LEVERAGE

|Includes: Bank of America Corporation (BAC), JPM, WFC

As a banker, though our industry has often benefitted from it, I have held the view for the past at least two decades that banking, as a business, is running on excessive leverage and has been poorly capitalized. It was thought banks could handle leverage prudently. Sadly, they cannot.

 

In any other business, a bank’s balance sheet would not merit even half the debt it is allowed to carry---and I am talking about US’s best and biggest banks. Long before the current financial crisis, the government should have done one of two things---mandated that banks should not be leveraged this irresponsibly, or forced them to have stronger capital base.

 

To prove my point with some stark facts: one of world’s largest and “stable” banks, Bank of America at Dec 31, ’08 had total interest bearing debt of $1.5 trillion. Their total equity: $178  billion. Which means their equity is only 11.8%. Which means for every dollar of their own, they borrowed more than eight dollars---from their depositors, from government and other banks. By comparison, IBM had interest bearing debt of $33 billion and equity of $13 billion---a healthy ratio of 39% equity. 

 

We routinely demand from businesses that they must have minimum equity of 25-30%. Heck, if the poor homeowner did not put down 20% of the purchase price as equity, he had to take out expensive insurance against mortgage default. And yet, carelessly, the government has permitted for years for banks to be undercapitalized. No wonder banks, no longer trusting, have stopped lending to each other. Their depositors now trust them even less.

 

I hope this is a wake up call---the long term solution for banks to be healthy is not more regulation or tax-payer hand outs but simply, a stronger balance sheet—one that has at least a 20 to 25% equity ratio. Even if banks have to get there by accepting US government as a partner.

 

I own stocks in major US banks - BAC, JPM and WFC