Will This One Change Eliminate Risk for Your Bank Stocks?

For years, shareholders of big banks Bank of America (BAC 2.06%) and Citigroup (C 3.06%) 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. 

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.)

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: 

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.