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How Healthy Is Your Bank?

With more failures expected in 2009, CFOs should subject their banks to a thorough checkup.

In the FDIC’s eyes, a well-capitalized bank has a ratio of Tier 1 capital to total risk-weighted assets of at least 6% (analysts prefer to see 8%); a ratio of total capital to total risk-weighted assets of at least 10%; and a Tier 1 leverage ratio of at least 5%. (Tier 1 capital includes common stock, some preferred stock, and retained earnings, among other things. The leverage ratio is Tier 1 capital divided by average total consolidated assets.) All three ratios can be found in Schedule RC-R (Regulatory Capital) of a bank’s call report.

The trouble is, the risk-based capital ratios “don’t work very well,” says Frederick Cannon, chief equity strategist at Keefe Bruyette Woods, specialists in financial services. That’s because the risk weightings that the government uses are out of date. For example, a mortgage-backed security is weighted at 20%, meaning that it requires one-fifth the capital of whole loans. “But some of those securities have declined in value a lot more than the values of whole loans,” says Cannon. The option ARM, which “proved to be an absolutely horrible product in terms of performance,” is weighted at 50%; “in hindsight it probably should have been weighted at 200%,” he says. As for the leverage ratio, “it doesn’t pay any attention to the composition of assets and their risk,” says Flannery.

Many investors no longer trust the regulatory ratios. Shareholders, conscious that they will be the first to lose if a bank fails, are turning to the tangible common equity (TCE) ratio as a better measure of solvency. The TCE ratio, which isn’t a GAAP metric, is tangible common equity divided by tangible assets; hybrid equity instruments and all intangibles are excluded. “It’s a harsh measure,” notes Whalen. There’s no general rule of thumb for an adequate level of TCE, but many analysts like to see a ratio of at least 4% for large banks and 5% or 6% for regional banks.

An officially well-capitalized bank may have a dangerously thin TCE ratio. Take Citigroup. At the end of December, the $1.9 trillion (in assets) bank holding company had a Tier 1 ratio of 11.9%, a total capital ratio of 15.7%, and a leverage ratio of 6.1%. (Capital ratios for bank holding companies can be found at the National Information Center’s Website, www.ffiec.gov/nicpubweb/nicweb/nichome.aspx.) But its TCE ratio was just 1.5%. Acknowledging the importance of TCE to investors, this past February Citigroup announced that it would offer to exchange up to $52.5 billion of its existing preferred stock for common stock, thus raising its TCE ratio to about 4%. “This securities exchange has one goal — to increase our tangible common equity,” said CEO Vikram Pandit.

All About the “A”

But the TCE ratio is not infallible. Right before Washington Mutual failed, its TCE ratio was 7.8%. For regulators and analysts, TCE is one more metric in the tool kit. That tool kit is typically based on CAMELS, the supervisory rating system that looks at a bank’s capital, asset quality, management, earnings, liquidity, and sensitivity to market risk (hence the acronym). Earnings are always important, but “these days it’s more about the ‘C’ and the ‘A,’” says Valentin.

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