How Much Capital Does Bank of America Need to Hold?

Under its Irish CEO Brian Moynihan, Bank of America has accumulated more than enough gold in the pot at the end of its rainbow. Image credit: iStock/Thinkstock.

One of the many challenges that Bank of America (BAC 3.35%) faces in the aftermath of the financial crisis is that it must operate with less leverage. This requires it to hold more capital relative to its assets than it did in the years before the crisis.

While there are four ways that regulators measure capital, the most important is the Tier 1 common capital ratio. This looks at the creme de la creme of bank capital, Tier 1 common capital, which includes common equity (i.e., not preferred stock), retained earnings, and other comprehensive income -- the latter reflects increases and decreases in the value of a bank's securities portfolio, among other things.

*References standardized approach and includes capital conservation and global systematically important bank buffers. Source: Bank of America's 3Q15 10-Q (page 62) and its 4Q15 financial supplement (pages 8-9).

Bank of America had $163 billion worth of Tier 1 common capital at the end of last year. This consisted of $151 billion worth of common equity and $88.6 billion worth of retained earnings, offset by $70 billion in goodwill (an intangible asset) and a $5.7 billion deficit in accumulated other comprehensive income.

To calculate the Tier 1 common capital ratio, this figure is then divided by a bank's risk-weighted assets, which amounted to $1.4 trillion at the end of last year. This yields a ratio of 11.6% for Bank of America.

This is more than enough capital to be considered a "well-capitalized bank," which frees Bank of America from "certain mandatory actions" regulators are required to take if a bank comes up short of this characterization. Banks that don't meet this threshold, for instance, are subject to restrictions on capital distributions (presumably above and beyond those incident to the stress tests each year) and discretionary bonus payments.

Bank of America's Tier 1 common capital ratio must be at least 10% in order to be considered well-capitalized for regulatory purposes. This figure is made up of a baseline of 4.5 percentage points that all banks must satisfy regardless of their size or systematic importance, 2.5 percentage points for a capital conservation buffer, and 3.0 additional points because Bank of America is classified as a global systematically important bank.

To put all of this into context, as of Bank of America's third quarter 10-Q, an increase in its Tier 1 common capital ratio by one basis point (that is, 0.01%) would require it to retain $139 million of its earnings. Alternatively, it could achieve the same result by reducing its risk-weighted assets by $1.2 billion.

At this point, building additional capital seems unnecessary, as Bank of America already has more than enough to be considered well capitalized. As of the end of 2015, its $163 billion in Tier 1 common capital exceeded the 10% threshold by $23 billion. This will be particularly beneficial in June, when Bank of America and the nation's other biggest banks request permission from the Federal Reserve to return more capital to shareholders.