After the Great Recession, regulators beefed up a lot of the rules governing banks, their lending practices, and how much regulatory capital they need to hold to ensure the safety and soundness of the global financial system.
Given that it's now been several years since the implementation of all of this complex regulation, I was surprised to hear Tom Michaud, the chief executive officer of the investment bank Keefe, Bruyette & Woods, recently say on S&P Global's podcast Street Talk that many banks today are about as leveraged as they were in 2007 right before the Great Recession.
With inflation high, interest rates rising, and the economy in a fragile place right now, it might concern investors to hear such a statement. But while a highly leveraged banking system might sound worrisome, there's no need to panic just yet. Here's why.
Breaking down Michaud's comments
Specifically, Michaud said that regional and mid-cap banks are leveraged as much as they were in 2007 when you look at the ratio of tangible common equity (shareholder capital excluding preferred equity, goodwill, and other intangible assets) to total assets.
And tangible common equity has been a good indicator of safety in the past. A working paper on bank risk conducted by the consulting firm McKinsey in 2009 found that 33% of banks with a ratio of tangible common equity to risk-weighted assets of less than 5.5% experienced "distress" during the Great Recession. But it can be a double-edged sword at times because too much tangible common equity can stifle returns and lead to lower valuations. This is why bankers, regulators, and politicians are always arguing about proper bank capital levels.
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However, regional banks weren't the only ones that have had leverage issues recently. Large banks like JPMorgan Chase (JPM -0.60%) and Bank of America (BAC 1.00%) worried last year about falling below their regulatory leverage requirements as well.
Why has this happened? Regulatory capital requirements have become much more stringent since the Great Recession and made the banking system much safer. Interestingly, Michaud noted that just a few years ago, banks were holding the largest amount of tangible common equity in 80 years. High levels of tangible common equity give a bank a greater ability to withstand loan losses, which tend to rise in economic slowdowns.
Two big things have happened, though, rather recently. First, the Federal Reserve has rapidly raised interest rates. This helps banks in one respect because higher interest rates increase the yield banks earn on loans and securities.
But it is also a headwind because banks often invest in bonds as an alternative to making loans -- and bond values have an inverse relationship with interest rates. Rising rates have resulted in banks taking some pretty heavy paper losses on their bond holdings in recent quarters. This has eroded their tangible common equity, the numerator in a bank's leverage ratio, or how much capital they have relative to total assets.
On top of that, quantitative easing by the Fed during the pandemic has injected trillions of dollars into the banking system, leading to a flood of deposits that banks ended up investing in bonds, which significantly increased the denominator in the leverage ratio.
It's a different kind of leverage
Despite the increase in leverage, Michaud made it very clear that the banking system today is a lot different than it was in the run-up to the Great Recession -- to which I would agree.
Before the Great Recession, bank held much a higher share of their assets in loans -- and what we now know to be much riskier loans that were not underwritten well. Not only have underwriting standards improved, but the banking system is much less leveraged to loans than it was. At the end of the second quarter of the year, JPMorgan Chase only had about 44.5% of its deposits deployed into loans. At Bank of America, that number is only about 50.4%.
Today, banks have deployed a lot more of their deposits in bonds. While banks are taking paper losses right now, as those bonds eventually mature, banks should see those paper losses go away as they receive the principal. That will bleed back into their capital, boosting tangible common equity. While loan losses permanently erode capital, paper losses on bonds usually come back and end up just being accounting noise.
Furthermore, banks are likely to see some of the deposits they have added since the pandemic run off as the Fed reduces its own balance sheet through quantitative tightening, which effectively soaks up excess liquidity from the economy. That might lower leverage by reducing bank balance sheets, but also could lead to less liquidity at banks as well.
No need to panic
While the banking system has become leveraged very quickly as of late, I do not see a need to panic. The leverage today is much safer, with more bonds -- instead of loans -- swelling bank balance sheets.
Furthermore, banks now adhere to much stricter regulatory capital rules, go through regular stress testing, and have much better lending standards.
While I'll be watching deposit trends and how bond losses on paper continue to affect tangible common equity in future bank earnings reports, I still feel confident that the banking system is prepared to weather whatever storm may be headed its way.
