Bank analysis takes more than one ratio

We do not usually comment on press articles, but this morning we were all quite surprised to read a piece on Bloomberg titled “A fragile banking system won’t make Europe stronger”. As we and many others have argued over the years, the banking sector globally has undergone an extensive process of improvement in credit quality, prompted by the banking crisis in 2008. Progress has been achieved in many areas including capital, simplification of business models, liquidity, and disclosure, amongst others - hence our surprise. The focus of the article is twofold; 

• The banks’ opposition to the final stage of Basel III implementation (which has to do with a revision of risk-based capital ratios). In the article it is argued that “any increase (in capital) from current levels would deliver a net economic benefit” and that more capital reduces overall funding costs. 
• They suggest that European banks are not well capitalised, as evidenced by the Credit Suisse events, and are on a low equity-to-assets ratio. 

We think this article and its conclusions are plainly wrong for the following reasons.

Firstly, although banks pursue an appropriate return on equity (RoE) just as any other private enterprise, it is worth noting that; a) they are very different animals than non-financial corporates, and b) that their willingness and ability to lend has a major impact on Gross domestic product (GDP) growth. Most economic activities use some form of debt, usually facilitated by a bank. In order for lending to be profitable, or in other words, for banks to achieve said level of RoE, banks run much higher leverage than a non-financial corporation. It is easy to demonstrate that, for example; if one sets up a bank purely with equity to give mortgages at 5%, then the RoE would be 5% minus wages, rent, bills and other expenses. This economic activity would deliver a poor RoE and would not be pursued by the private sector with negative side effects for GDP.

Therefore, logic suggests that there is an optimal level of leverage that marries systemic risks of having too much leverage with banks’ ability to obtain a commensurate RoE. It follows that not any increase in the banking system’s capital would deliver an economic benefit. If banks are unable to lend profitably, they just won’t do it. This would have tangible negative consequences for growth, particularly in those capital-intensive sectors such as infrastructure, telecoms, and utilities with a corresponding impact in unemployment and potential growth in the economy. It is also not obvious that more capital would always reduce overall funding costs. If banks are loss making because they cannot lend in a profitable manner and economic growth takes a hit, then we have doubts that investors would be queuing up to provide them with funding.

Secondly, we believe that banks in Europe and across the world do not have a capital problem. The metric the article uses to evidence the supposedly poor capitalisation of the system is a simplistic equity divided by assets calculation, which in the case of Europe, peaked at just over 5%, it is argued. The best example as to why this is an incomplete measure of a bank’s ability to remain solvent is to look at Silicon Valley Bank (SVB). In their Q4 2022 financial statements, which were their last before they went bankrupt, SVB showed a healthy 7.96% leverage ratio. Other relevant examples are Signature Bank and Credit Suisse that showed leverage ratios of 8.79% and 7.7%, respectively in the same quarter. In the same period, HSBC’s figure was 5.8% and Nationwide Building Society’s was 5.4%. There is a reason why regulators (and markets) arrived at the conclusion that there are several ratios and indicators, as well as qualitative analysis, that need to be considered when assessing a bank’s financial health. Measures of equity over assets such as leverage ratios are only one of these.

Another one regulators and markets look at are risk-weighted capital metrics such Common Equity Tier 1 (CET1) that, instead of using the total assets figure on the balance sheet, use an adjusted figure with the aim of reflecting the riskiness of the assets on the balance sheet. This is a good idea, and makes perfect sense, as it allows for comparisons between banks that have different business models. If one bank is in the prime mortgage business and the other lends to start-ups, of course you have to adjust the asset quality before comparing them. As long as disclosures on how this is calculated are available, CET1 ratios and other risk-based metrics are a useful part of regulators and investors toolkit for analysing banks. The final stage of Basel III implementation that implies a revision of the risk-weighted assets calculations is likely to translate into higher equity requirements. We agree with some bank management teams’ comments that increasing capital levels of large banks further is not necessarily a net positive for the economy, as lending would take a hit just to make well capitalised banks, even better capitalised – to reiterate again, the marginal benefit of additional capital diminishes as the quantum of this capital grows higher.

The problems of SVB and Credit Suisse last year had little to do with capital. The former had a large concentration of depositors and large unrealised losses in government bonds due to poor hedging policies. The latter experienced a crisis of confidence after a number of risk management scandals which culminated in a deposit flight and the regulator’s questionable decision of writing down AT1s while selling the bank to UBS. There is no guarantee that if both SVB and Credit Suisse had more capital, their future would have been different.

We remain confident that the global banking system, Europe included, continues to be well capitalised and that credit quality continues to improve. Evidence of this can be found in the numerous ratings upgrades the sector has had over the last few quarters (and years), the healthy results shown by regulatory stress tests and the lack of contagion when individual banks, that have in fact made bad decisions, get into severe trouble. We keep calm, although as always vigilant, and carry on.