Which Megabank Will Need to Raise Capital?

Bank share investors need to remain alert. On Monday, S&P released a report in which it produces its own risk-adjusted capital (RAC) ratio for 45 of the largest banks worldwide. The average -- 6.7% -- is more than three full percentage points below the average Tier 1 capital ratio (the standard measure of capital strength under the Basel II capital adequacy framework). Four out of five banks in the sample failed to achieve the minimum 8% RAC necessary to cover the level of financial stress modeled by S&P.

Citi without the Basel II lipstick
At Citigroup (NYSE: C  ) , the difference between the RAC and Tier 1 capital ratios is more than 10 percentage points (see table below)! With a Tier 1 ratio of 12.7%, Citi appears solidly capitalized, but a RAC of just 2.1% tells a very different story, relegating Citi to the next-to-last spot on S&P's global list.

Bank

S&P Risk-Adjusted Capital Ratio (June 30, 2009)

Tier 1 Capital Ratio (June 30, 2009)

Goldman Sachs (NYSE: GS  )

8.3%

16.1%

Morgan Stanley (NYSE: MS  )

8.1%

15.8%

JPMorgan Chase (NYSE: JPM  )

7%

9.7%

Bank of New York Mellon (NYSE: BK  )

6.5%

12.5%

Wells Fargo (NYSE: WFC  )

6.4%

9.8%

Bank of America (NYSE: BAC  )

5.8%

11.9%

Citigroup (NYSE: C  )

2.1%

12.7%

Source: Standard & Poor's report and Capital IQ, a division of Standard & Poor's.

S&P's handwriting on the wall
S&P's RAC ratio is lower than the standard Tier 1 ratio because it is less inclusive with respect to what banks can count as capital and it penalizes risk more heavily. Unfortunately, banks can't ignore this change in methodology, for two reasons:

  • S&P will begin using the RAC ratio in determining bank credit ratings; thus, it could directly affect a bank's funding cost.
  • The Basel Committee on Banking Supervision -- which devises capital adequacy standards -- has already made recommendations that are consistent with a tighter interpretation of regulatory capital.

Beware of share dilution
The results of S&P's analysis suggest that Citigroup will almost certainly need to raise additional capital to meet new regulatory requirements. Although their case is less pressing, the other banks in that table may have to do the same -- even the investment banks; bank share investors should be mindful of the risk of dilution.

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Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 25, 2009, at 11:04 AM, nastratin wrote:

    It's all good, but, if you actually read S&P's report, and not copy paste from press articles, you will find that RAC ratios were calculated based on Jun 2009 numbers, or even older: e.g. Dec 2008 in same cases.

    Citi did a massive pfd exchange since then (closed July), which increased its capital ratios significantly. Other banks did similar transactions and/ or secondary offerings.

    Assets were sold, profits,or losses were made in Q3, etc, etc. - all have an impact on RAC...

    S&P's attempt to come up with a consistent measure across all regulatory regimes, and which reflects better financial risks, is good, in principle. Using old data was unfortunate, if not irresponsible.

  • Report this Comment On November 25, 2009, at 12:37 PM, TMFAleph1 wrote:

    @nastratin,

    Thanks for your interest, but as a point of fact, I did read S&P's report rather than "copy pasting from press articles". If you look at the table in my article, you will note that the date associated with the RAC ratios is clearly indicated in the column heading.

    Your wider point is useful -- it would certainly be interesting to look at updated RAC ratios for the third quarter. Nonetheless, I'd be willing to bet that a good number of the banks in S&P's sample will need to raise additional capital.

    Finally, there is nothing "irresponsible" about using the data that is available to you at the time, providing you indicate the date for your results -- which S&P did.

    Alex Dumortier

  • Report this Comment On November 25, 2009, at 12:38 PM, TMFAleph1 wrote:

    @nastratin,

    Thanks for your interest, but as a point of fact, I did read S&P's report rather than "copy pasting from press articles". If you look at the table in my article, you will note that the date associated with the RAC ratios is clearly indicated in the column heading.

    Your wider point is useful -- it would certainly be interesting to look at updated RAC ratios for the third quarter. Nonetheless, I'd be willing to bet that a good number of the banks in S&P's sample will need to raise additional capital.

    Finally, there is nothing "irresponsible" about using the data that is available to you at the time, providing you indicate the date for your results -- which S&P did.

    Alex Dumortier

  • Report this Comment On November 25, 2009, at 12:52 PM, rd80 wrote:

    Even though it doesn't need to raise capital, Wells Fargo should do it before the end of the year.

    With the capital raised for last year's Wachovia buy and the stress test capital raise earlier this year, Wells is very close to what it needs to wipe out half the warrant shares held by Treasury under TARP.

    One relatively small share issue before the end of the year raises capital and takes a fair amount of future share dilution out of the picture.

  • Report this Comment On November 25, 2009, at 12:56 PM, TMFAleph1 wrote:

    @nastratin,

    While RAC ratios may have improved during the third quarter, note that, on Monday, the head of the IMF told the Confederation of British Industry's Annual Conference that close to half of total bank losses remain undisclosed (He did say that the proportion is greater in Europe than in the U.S., however).

    http://www.thisislondon.co.uk/standard-business/article-2377...

    In his formal address, he also said that "banking systems in many advanced economies remain undercapitalized, weighed down by leaden legacy assets and, increasingly, non-performing loans."

    Alex Dumortier

  • Report this Comment On November 25, 2009, at 12:57 PM, TMFAleph1 wrote:

    Here is the link to the full text of Strauss-Kahn's formal address to the CBI Conference:

    http://www.imf.org/external/np/speeches/2009/112309.htm

    Alex Dumortier

  • Report this Comment On November 25, 2009, at 5:34 PM, jorge8888 wrote:

    My god your so funny. Next time I do hope you do your homework best.

    DO you know where RAC rations stand TODAY for this institutions? Any clue?

    If yes, why don't you say it in your article, If you have no clue, how can you say they will need to raise capital... I'm not saying that will need or not, but based in the info in your article, ratios in June, whith all the capital raising efforts since than is just not too professional.

    Next time, why don't you write about the Big-Ban or Darwings evolutionary theory. If you do copy paste, it will at least be more accurate.

    Anyway... funny reading.

  • Report this Comment On November 25, 2009, at 7:25 PM, TMFAleph1 wrote:

    @jorge8888,

    Are you always this ill-mannered when you are interacting with people for the first time or only when you can do so anonymously over the internet?

    S&P has not produced RAC ratios for the third quarter -- I can't make those figures up. However, despite "all the capital raising efforts" you refer to, the Tier 1 Capital ratios for the 7 banks did not increase significantly between the second and third quarters (in fact, the Tier 1 ratios of Bank of New York Mellon, Goldman Sachs and Morgan Stanley actually decreased) -- there is little reason to believe that the RAC ratios increased substantially over the same period.

    By the way, it's the 'Big Bang' and 'Darwin', not 'Big-Ban' and 'Darwing'.

    Thanks for your interest,

    Alex Dumortier

  • Report this Comment On November 25, 2009, at 10:54 PM, jbenaven wrote:

    I must say this is borderline irresponsible, Your ratios are based on old data. We have no accountability for articles these days. People can pretty much publish anything. These things have an effect on the market (specially with those titles). Now think about this question. What's the point of your article? Whatever reaction you get, it will just be based on old data.

  • Report this Comment On November 26, 2009, at 12:27 PM, TMFAleph1 wrote:

    @jbenaven,

    'Irresponsible' is buying or selling shares based on the misreading of a single article. The date associated with the two ratios is prominently indicated in the table headings -- investors need to be accountable to themselves, rather than trying to find a scapegoat for their ill-considered actions.

    Thanks for your interest,

    Alex Dumortier

  • Report this Comment On November 26, 2009, at 7:04 PM, tkell31 wrote:

    Dates are displayed, but you dont make any mention that the ratios have changed anywhere in the article or acknowledge that capital raising efforts in the interim may have already addressed the issue.. Relying on a rather vague statement (I dont know about you, but when talking about trillions of dollars would like a figure a little more concrete then what was said in the article) that isn't referenced anywhere in your article as support for the fact that some of the banks may still need to raise capital is, for lack of a better word, lazy journalism. If you are going to reference a key fact like that as support for your premise then it should be in the article. Great idea to alert investors to the potential, key word, potential share dilution they might face, but without key facts it looks more alarmist then informative.

    Happy Thanksgiving to everyone! Hope everyone is enjoying the truly awful football on today.

  • Report this Comment On November 26, 2009, at 7:24 PM, TMFAleph1 wrote:

    tkell31,

    Thanks for your interest. Please refer to my response to jorge8888 to see why the warning in the article is absolutely relevant, despite the fact that the ratios contained in the S&P report are based on Q2 data.

    Alex Dumortier

  • Report this Comment On November 26, 2009, at 8:12 PM, tkell31 wrote:

    Looks like I wasnt very clear. My concern wasnt with the relevancy, but with the fact that two releveant facts you were aware of were not mentioned in the article. First, there is a belief that up to half of all toxic assests have not been revealed and second, some, if not all, of the banks on this list, have taken measures to address the capital ratios since the study was conducted. I point to your statement: "At Citigroup (NYSE: C), the difference between the RAC and Tier 1 capital ratios is more than 10 percentage points (see table below)!" That leads the reader to conclude, incorrectly, that this is the current shortfall at C. I believe the use of the word is, as in present tense, indicates a current situation. In fact it doesnt appear that you know what it currently is, but you make no mention of that fact nor do you offer any disclaimer. On the contrary you draw the conclusion C will almost certainly need to raise additional capital further diluting the stock. It may seem trivial to you and you may assume that anyone reading the article would do due diligence to determine what, if any, impact the current shortfall would have on the value of the stock, but adding two sentences would have made it clear and added to the value of message. Ironically I got tired of holding c as it went no where and sold it off two weeks ago to buy APWR. May all your investments be ten baggers!

  • Report this Comment On November 26, 2009, at 10:07 PM, jbenaven wrote:

    Alex, my friend, this is the type of lazy work that if you worked for me, I would have you fired. Again, I'll ask the same question. What's the point of your article? Happy thanks

  • Report this Comment On November 29, 2009, at 2:32 PM, copperbeeches wrote:

    Boys, boys:

    As a fool who pays good money for MF services, and has far less time to waste than you obviously do, let me say that I don't appreciate the garbage mixed in with some of these comments.

    Alex's article makes a good point. Even those of us fools who are too simple to keep up with S&P reports on our own were able to spot the date in the chart and understand that the data isn't current. Those who made counterpoints, fine; but make your point and save your ego-enhancing comments for your significant other (pet?). The rest of us are only interested in your argments, not looking for a cat fight.

  • Report this Comment On November 30, 2009, at 1:29 PM, TMFAleph1 wrote:

    Thanks for your support, copperbeeches. Much appreciated!

  • Report this Comment On December 03, 2009, at 10:49 PM, tkell31 wrote:

    Copper, I believe you also miss the point in that it was a poorly written piece and as my grand pa used to say, anything worth doing is worth doing well.

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