Will This One Change Eliminate Risk for Your Bank Stocks?

Tier 1 capital requirements are becoming more stringent -- but does that really mean anything?

Feb 21, 2014 at 7:35AM

For years, shareholders of big banks Bank of America (NYSE:BAC) and Citigroup (NYSE:C) have been hearing about new regulations that could cripple profits. Now, new regulatory requirements for bank capital are being phased in for large banks worldwide. Is this the beginning of an easy breezy new era for risk management? Put simply: I don't think so. 

Hatt

What is Tier 1 capital?
In the wake of the financial crisis, the guidelines for Tier 1 capital, or a bank's core capital base, were variously analyzed, criticized, and discussed. In response, the group that develops these standards, the Basel Committee on Bank Supervision -- often referred to simply as "Basel," and often pictured in my mind as a charming older Swiss gentleman in a derby cap (don't ask) -- came together to strengthen liquidity and capital requirements for the banking sector, and particularly for globally significant banks.

The result is Basel III, a new set of guidelines regulators are phasing in worldwide. One of the new rules alters the definitions and requirements of core capital, especially for the foundational Common Equity Tier 1 (CET1) capital. A bank's CET1 ratio must now be a minimum of 4.5%. 

At its most essential level, the CET1 ratio is calculated by adding up the allowable components of CET1 capital and dividing by the risk-weighted asset base. (Of course, nothing is actually this simple in practice, but it gives you the basic idea.)

Cet

There are a few different methods of calculating the CET1 ratio, but banks are required to use the one that produces the lowest ratio. Adding a few permissible assets to CET1 gives you the Total Tier 1 capital, which, under the new regulations, must be a minimum of 6% of risk-weighted assets.

Why should we care?
Research supports the notion that Tier 1 capital levels were an important predictor of bank performance during the financial crisis. How important? A European Corporate Governance Institute paper found that, controlling for country effects, a one standard deviation increase in Tier 1 capital was associated with an improvement in bank performance of almost 15%.

In other words, being one standard deviation above average in terms of Tier 1 made for 15% better performance during the onset of the financial crisis. Logically, the recent changes making the definition of Tier 1 more stringent could make it an important predictor of safety and stability in times of crisis. But does it give you the whole story? 

A look at CET1 ratios
A small sampling of banks gives the following fourth-quarter CET1 ratios from 2013: 

 

CET1

Required CET1 Buffer

Deposits to Assets Ratio

JPMorgan Chase (NYSE:JPM)

9.5%

2.5%

53.3%

Citigroup

10.5%

2%

51.4%

Bank of America

10%

1.5%

53.2%

Wells Fargo (NYSE:WFC)

9.8%

1%

64%

State Street (NYSE:STT)

10.1%

1%

74.9%

Source: Company filings.

Very large banks, known as Global Systematically Important Banks (G-SIBs) are subject to additional capital requirements under Basel III, meaning they are required to hold more CET1 assets than other banks. JPMorgan is one of only two banks to carry the highest required buffer of 2.5%, compared to Citigroup's 2% requirement and State Street's 1%.

To get to these numbers, banks are assigned to "buckets" based on their relative importance to the global financial system. At this writing, each of these banks has reached their Basel III targets for CET1. 

The end of risk? 
I'm not convinced sufficient CET1 ratios mean we can all stop worrying about systemic shocks. While higher CET1 ratios will probably help buffer bank performance during hard times, this number shouldn't become synonymous with safety. Risk-weighting is an arbitrary exercise at worst, and an imperfect one at best, and it won't alter the incentives facing risk-seeking institutions looking to bolster returns at all costs. 

CET1 should be looked at alongside other risk factors like the deposit base relative to assets, liquidity measures, and a bank's income sources. To give one example, there is quite a range of deposit-to-asset ratios among these banks. State Street has a ratio of nearly 75% compared to Citigroup's 52% -- despite very similar CET1 ratios, there are clear differences in each bank's underlying strategy. 

So, use CET1 in your analysis, but don't let it lull you into skipping the rest of your homework. 

A big risk to big banks
Do you hate your bank? If you're like most Americans, chances are good you answered yes to that question. While that's not great news for consumers, it certainly creates opportunity for savvy investors. That's because there's a brand-new company that's revolutionizing banking, and is poised to kill the hated traditional brick-and-mortar banking model. And amazingly, despite its rapid growth, this company is still flying under the radar of Wall Street. For the name and details on this company, click here to access our new special free report.

Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers