Just as blood pressure and heart rate are vital measures of physical health, capital ratios are vital measures of the health and solvency of banks. Now, in the midst of a banking crisis the IMF calls the worst since the Great Depression, those vital signs reflect a sick industry that's getting sicker.
Capital ratios are federal regulatory benchmarks set to put a safety cushion of capital in reserve that would cover possible losses as well as an accounting of a bank's financial situation.
One capital ratio for banks is a measurement of capital (which includes common stock, preferred stock, and retained earnings) as a percentage of risk-weighted assets. To be considered a well-capitalized bank by regulators, a bank's capital must represent more than 10% of risk-weighted assets.
What's been happening?
Here's the problem. Rating agencies, criticized for slacking as the subprime crisis developed, have been making up for lost time and downgrading subprime-infected assets almost arbitrarily, and they're hungry for more. By lowering the ratings of higher-risk assets held by banks, the risk-weighting of the assets increases, thus reducing a bank's capital ratio.
FDIC Chairwoman Sheila Bair warned that downgrades could cause many of the largest U.S. banks to fall below a well-capitalized level. The last thing banks want to do is fall below their regulatory benchmarks. That could subject them to ugly consequences such as debt rating downgrades, negative press, and an increase in regulatory scrutiny.
Many banks have seen their capital ratios fall precipitously, and now they have the thinnest safety cushions in years. According to Bloomberg, regulated banks in general had a capital ratio of 12.79% at the end of 2007, the lowest since 2000. However, the ratios of some of the largest banks are far worse and falling.
What's the overall effect?
Overall, it's bad news for investors. Falling capital ratios will create a huge demand for bank capital. In order to raise capital to preserve their ratios, banks must discontinue share repurchases, issue more stock, and cut dividends. They have to stop doing all the things that make money for shareholders and invest instead in their own survival.
The scariest part is the negative effect that's possible for the entire economy. The credit crisis has already cost banks a total of $232 billion and, according to Bloomberg, banks have already raised $136 billion in capital. If the crisis continues, banks will be forced, as a last resort, to reduce lending activity to protect their balance sheets.
The erosion of the capital ratios at some of the nation's largest banks is Ground Zero of the credit crunch. If this situation continues, banks will decelerate lending activity; a mild recession or slow-down could turn into something far worse.
To gauge how bad this crisis is and how bad the economy will get, keep an eye on these ratios.
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JPMorgan and Bank of America are Income Investor recommendations.