Shareholder Equity As a Predictor of Risk

Motley Fool analyst Matt Koppenheffer sits down with Rick Engdahl for a side-of-desk interview about banks. Are they really that hard to understand? Can the big banks be trusted? Join us for a discussion that sheds some light on banks from Citigroup  (NYSE: C  )  to Wells Fargo  (NYSE: WFC  ) , as well as some of the smaller players.

In this video segment, Matt explains how tangible shareholder equity prior to the financial crisis provided a clear indication of risk at the biggest banks -- and what those institutions are doing to assure it doesn't happen again.

A full transcript follows the video.

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Matt Koppenheffer: Here's the interesting thing when it comes to capital ratios. One of the things that I've looked at is, I've gone back and done a really simple calculation, which is just look at the tangible shareholder equity. You take out goodwill, you take out intangible assets from shareholders' equity. You take the tangible shareholders' equity, and you look at that as a ratio to assets.

If you go back and you do this prior to the financial crisis, of the biggest financial institutions -- those with $50 billion or more on their balance sheets -- it doesn't end up being all that surprising when you sort by the lowest ratio, so who would be most at risk?

You see Bear Stearns up there. You see Lehman Brothers up there. You see Merrill Lynch up there, Citigroup, Bank of America. They're all right up there. You can see plain as day that on that very simple calculation, those are all institutions that were at risk.

I think that, for investors, is a great way to look at the capital ratios and the safety of the banks. In terms of where we are today versus where we were then, if I remember correctly I believe the median ratio of that particular measure was around 4%, so 4% tangible shareholder equity to total assets. It was about 4% back then ... or, no, it was 4.6%.

Today, it's up over 7% on the median, and you've got a lot of banks that have gone well above that. Citigroup, actually, is way above the median now. Wells Fargo, above the median.

The banks are moving in the right direction as a group, but also individually in terms of making their balance sheets safer and making their business overall safer.

Investors can follow, and probably should follow, when the banks talk about, "Well, we have X percentage of Basel III Tier 1 capital." You can get a sense for what that means, and you can compare that easily across the banks, because all the banks are trying to do the calculations similarly.

Because this isn't firmly in place yet -- we don't have the finalized rule, and there's still a lot of discussion about how things are calculated -- but they're all trying to calculate it basically the same, so you can compare those across banks and you can get a relative idea of who's safer than the next.

But I think this particular measure -- the tangible shareholder equity to total assets -- it's an easy thing to look at, and I think it gives investors a pretty good look at how safe the banks are.

Capital and safety has been a big issue for the banks.


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