Blogs & Comment

How strong are Western banks?

Data on bank solvency indicate American banks are doing OK (on paper), European ones are troubled and Canadian outfits are resting dangerously on their laurels.

A BNP Paribas SA bank in Paris, France (Photo: Chris Ratcliffe/Bloomberg/Getty)

Like an irresistible oceanic current, the financial crisis continues to swirl around the globe, its waves lately lapping on the beach at Paloma Plage in France and infiltrating the Rhine in Germany. To hear the market tell it, their picturesque fate rests not only on the balance sheets of their governments, but on those of the banks in those countries and beyond. So how strong are the world’s biggest banks? How are Canadian banks doing, for that matter?

To find out I looked at three banking metrics: the Tier 1 core capital ratio, leverage ratio and loan-loss provision. Each metric looks at a different aspect of a bank’s ability to withstand economic shock.

Tier 1 core capital (higher is better)
Tier 1 core capital (or common equity as it is formally called by the Bank for International Settlements) measures a bank’s equity position relative to its assets. It essentially asks, how strong is the foundation on which the bank’s wealth is built? Eligible capital includes common equity and declared reserves, minus certain classes of preferred shares, goodwill and hybrid capital. This is then divided by the total for risk-weighted assets. Because of the deductions it’s considered a finer measure of financial strength than the Tier 1 capital ratio.

Ongoing negotiations between the world’s banking regulators via the Basel II Accords are attempting to tighten the definitions of qualifying capital to try and shore up bank capital.
As of December 2010 an additional proposal has been tabled to raise the capital requirements for counterparty risk. This, together with Basel II, has been named Basel III, with a timeframe for implementation of 2013-2018. If adopted, the new rules will require a minimum tier 1 core capital ratio of 7%, a number all the big banks already reach—at least on paper. Most of the world’s regulators have reported that they will implement Basel II by 2015. (On the other hand, it bears noting that most of the financial industry has come out against Basel III, claiming it will harm long-run GDP growth.)

Click the image (above) or here for the tier 1 core capital chart.

Leverage ratio (lower is better)
The leverage ratio measures Tier 1 capital (not core capital) as a percentage of assets. Equity and assets are adjusted to remove goodwill and intangible assets, but include deferred tax liabilities. The figure is reported here as a multiple (e.g. 20x, meaning 20 times leverage) instead of a percentage, because it better displays how much leverage a bank is using to generate the wealth represented by its assets.
While there isn’t anything intrinsically wrong with high leverage, it does mean the bank would be in a more precarious position were it ever called upon to dip into its equity to cover any claims on its assets, and, to use a homeowners’ analogy, it may mean the bank is taking on “too much house” relative to its ability to support the mortgage. In the current economic climate, where banks have been trying to deleverage in order to reduce their exposure to adverse market conditions, a lower number is probably more prudent.

Click the image (above) or here for the leverage ratio chart.

Loan loss provision (higher is better)
The loan loss provision represents the amount of money set aside, as a percentage of the loan portfolio, to cover failed loans and credit. This is a significant metric because of the economic downturn’s potential effect on a customer’s ability to repay loans.
Loans that can’t be paid become impaired, then go bad and finally are written off for a loss. Banks like to try and get away with as small a cushion as possible because any money set aside subtracts from the balance sheet and is unavailable for things like retained earnings (equity), dividends, salary bonuses and the like.

Click the image (above) or here for the loan loss provision chart.

The current climate

Ironically, despite the U.S. banking system being the epicenter of the financial crisis back in 2008, today American banks appear to be much stronger relative to their peers. (Systemic risk is another matter entirely, since they’re all bigger than they were in 2008 and too-big-to-fail is therefore more entrenched than ever.) Companies like Bank of America and Wells Fargo have socked away far more for loan loss provision than the industry average, for example. That shouldn’t be surprising given the ongoing housing disaster in the U.S. But even their capital positions have improved and all sport decent Tier 1 core capital ratios. On the other hand, this may be illusory since there is almost certainly hundreds of billions in bad loans that have yet to work their way through the system and asset values are probably inflated because mark-to-market valuation has been suspended for years now.

Canadian banks are middle of the road at between 8%-10% when it comes to the capital ratio, but sport surprisingly low loan-loss provision rates. BMO and RBC hover around 1% while CIBC skips by with almost nothing at 0.11%. It’s true that with derivatives hedging, securitization and considerations for the quality of the loan portfolio, these provisions may not be as bad as they look, but as gross indicators they’re not encouraging. It may simply be that the banks are taking advantage of a housing and employment market that has remained relatively robust throughout the economic downturn to get away with a less insurance. But globally, Canadian banks are worryingly thin here.

By leverage, all the Canadian banks are in the 20x range, which puts them in recent historical average territory and compares favourably with their peers, though higher (worse) than the rapidly deleveraging American banks

The European banks are another, much sadder story. They’re well into the 30x range. Giants like Credit Suisse and Deutsche Bank soar into the 40s at 41.6 and 48.9, respectively. A failed bank, like the Belgian/French Dexia is in the stratosphere at just over 100x. Their capital ratios are generally in the 10% range with some standouts like UBS, which has managed to pump up reserves to an industry leading 16.1%; but it also has one of the lowest loan-loss provisions at 0.29%.

Despite some of these seemingly weak numbers, only five of 93 European banks failed the 2011 stress tests conducted by the European Banking Authority. Depending on how so-called contagion plays out in the eurozone, these results may yet need revision. American banks were also stress tested in 2009, returning a similarly celebratory result but to dubious public reception. It’s little known that Canada’s banks have also been stress tested (2010), but that would be because the results have been kept secret by the Office of the Superintendent of Financial Institutions.

A spokesman for the OSFI tells me stress tests are conducted regularly, adding in written communication: “Since stress testing should be embedded in the practices and culture of the institutions we supervise, it would be inappropriate to disclose the internal estimates used by the financial institutions’ risk management area and reviewed and approved by the financial institutions’ Boards of Directors.”

A very Canadian answer. But in this age where the world’s livelihood depends to a great degree on the behavior of banks, that may not be good enough.

Notes
TD Bank is not included on the chart for Tier 1 core capital because it does not report this figure.

Goldman Sachs is not included on the chart for loan-loss provisions because it does not make loans. It was converted into a bank holding company in 2008 as a technicality to allow it to receive government bailout funds.

The leverage ratio calculation takes into account the amount for deferred taxes. Where this figure is not broken out and reported to include current taxes as well, half of the total figure is assigned to deferred taxes.

The leverage ratio calculation takes into account the amount for intangible assets. Where this figure is not broken out and reported to include tangible assets as well, half of the total figure is assigned to intangible assets.

All data are from bank Q2 2011 reports.