Leveraged Banks: How Much Is Too Much?

Motley Fool analyst Matt Koppenheffer sits down with Rick Engdahl for a side-of-desk interview about banks. Are they really that hard to understand? Can the big banks be trusted? Join us for a discussion that sheds some light on banks from Citigroup (C 1.58%) to Wells Fargo (WFC 2.27%), as well as some of the smaller players.

In this video segment, Matt explains leveraging and its effect on banks' stability, as well as the Basel regulations and their attempt to avert future crises by regulating capital. Deposits and loans may be simple to understand, but regulatory capital is where banks get their reputation for complexity.

A full transcript follows the video.

Matt Koppenheffer: Now, in terms of where the banks are today, I think looking back at the second quarter, at least, we're halfway through the year at this point, and one of the big themes is capital. The capital issue is, how much buffer do banks have? If a bank loses money, how much buffer does it have before it's really in trouble?

Something that's characteristic of a bank is that they're relatively highly leveraged, compared to other businesses. Most businesses don't borrow nearly as much as banks.

When I say "borrow," I mean both long-term debt, which is the kind of debt that you'd see at an Apple or GM, or those kind of businesses, but then also the deposits that customers give the banks, the CDs that banks issue, money market funds that people take out of banks; that's all considered debt there, too.

Typically, a relatively safe bank would be considered levered at somewhere like 10 to 1, 12 to 1, that kind of range. What that does is, it means that, when there's a loss on the assets -- banks hold all kinds of assets: loans, government securities, mortgage-backed securities, the kind of stuff that Fannie Mae and Freddie Mac churn out -- when they have a loss on there, it's magnified in their shareholder equity, their book value, because of that leverage.

When we look back, before the financial crisis happened, one of the things that banks were doing was they were keeping less and less and less capital. The amount of capital that they held, versus the amount of assets that they had on their balance sheet, was getting way out of whack. The threat that you had was that a very small loss on those assets creates a very big problem for the bank.

The regulatory capital that the banks have to hold, that gets really complicated. When you talk about banks being complicated, that stuff will make your head swim.

In the U.S., we adopted what was called Basel I. This was an international set of regulations that dictated how much capital needed to be held, but also how the capital is calculated. That's what we've been using for a long time.

There was a Basel II standard that came out, that we haven't really adopted. Part of that was that it used risk-weighted assets to calculate how much capital the banks had to hold, and there were some concerns over how the risk weighting worked.

Essentially, what you're doing there is you're saying, "Well, this asset is particularly risky, so you have to hold a lot of capital against it. This asset is less risky, so you don't have to hold as much capital against it."

Not only does that make for less certainty, and make things a little bit more murky, but the calculations, there's a lot of ... "room for discussion" I'll say, rather than put a cynical view on it. There's room for discussion in there.

Now we're working on the Basel III standards, which looks like it's going to be implemented in the U.S. and around the world. I don't know that it really makes things more clear. I think it'll make banks a little bit safer, but it doesn't make things more clear.

I think the full Basel III regulations is like 900 pages. I'll readily admit I have not read all 900 pages.

Rick Engdahl: What is "Basel," is that a ...?

Matt: Switzerland. For the city or town.

Rick: Oh, it's a location.

Matt: It's a location, yeah.

Rick: Got you.

Matt: It's the Basel Committee, sitting there in Switzerland -- where else -- writing 900 pages' worth of banking regulations, which floats some people's boats, I guess.

Rick: Is it like one of those camera manuals, where it looks like a lot of pages, but it's really because it's translated into so many languages?

Matt: No. Unfortunately, it's not. I wish that were the case.