The One Thing Banks Wish You Would Forget About

Off-balance sheet exposures could render your bank’s capital ratios meaningless. How do you adapt?

Mar 12, 2014 at 7:31AM

Source: Wikimedia Commons.

As I've discussed previously, banks have gotten onto the Tier 1 capital bandwagon and are boosting capital levels ahead of the new Fed-mandated schedule. The idea of strengthening the rules is really great -- there is evidence that higher Tier 1 can help see a bank through a crisis, which is something I imagine every financials investor probably thinks about these days. 

As helpful as capital levels are, there is unfortunately an issue of relevant information. Tier 1 is essentially calculated by dividing the components of core Tier 1 capital by a bank's risk-weighted assets. Again, great idea -- except that asset levels are not always what they seem.

Hello, off-balance sheet assets
Banks are allowed to keep an enormous amount of information off the balance sheet. To give you an understanding of this, consider another proposed change to the Basel standard (since pulled back): A reporting requirement would have raised the total assets of the eight largest American banks from $10 trillion to about $17.5 trillion. 

That means that as of today's standards, about $7.5 trillion in assets are floating around, but they aren't included on the balance sheets of these banks. We don't know what they are, where they are, or how risky they are.

This begs the question of how accurate Tier 1 really is -- including off-balance sheet assets could completely change the picture for measures of liquidity, capital, and exposure. How are you supposed to make informed decisions without this information?

Don't rely on Tier 1 -- or ANY -- single ratio For that matter
It just drives home that age-old wisdom about doing your homework. Tier 1 can give you a starting point for assessing certain kinds of risk, but it's far from comprehensive. 

The fact is we have to invest with incomplete information, so be sure to use other measures and methods when looking at a bank's activities and risk factors. I personally like to analyze income sources because they tell you a lot about where a bank is focusing its resources. They can also give you an indication of a bank's exposure to the overall economy (there is evidence that non-interest income is more correlated to general economic movements than interest income).

For example, Citigroup (NYSE:C) and State Street (NYSE:STT) have comparable Common Equity Tier 1 ratios, at 10.5% and 10.1%, respectively. However, Citigroup is pulling down 66.5% of its revenue from net interest, versus State Street's 24%. Does that mean Citigroup is more conservative? Well... Citigroup's income from principal transactions rose 49% from 2012 to 2013, its realized gains on investments rose 77%, and, of course, Citigroup is a much larger bank, which you might also want to factor in to any analysis.

The point is that to really understand Citigroup's position on the spectrum of risk, you're going to have to keep asking questions and digging around until you find the answers. Like most things in life, there's just no quick fix, particularly when you become aware of how little information we actually have.

One piece of information is not the whole story
So don't let the triumphant reporting of Tier 1 capital ratios -- or any other ratio, for that matter -- lull you into believing that insolvency risk is a thing of the past. More importantly, remember that when it comes to the looming influence of off-balance sheet exposures, you are simply going to be in the dark until the rules change.

Just keep it in mind: $7.5 trillion. It's a big number. 

Not just assets flying under the radar, but an entire bank
Do you hate your bank? If you're like most Americans, chances are good that 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 owns shares of Citigroup. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

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