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Obsolete Dogma: Higher Capitalized Banks Aren't Necessarily Safer

By John Maxfield – Feb 1, 2016 at 5:54PM

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The fact that Dodd-Frank has reduced leverage at the nation's biggest banks doesn't in and of itself make the financial system safer.


Even a lot of capital can be overwhelmed by poor risk management. Image source: iStock/Thinkstock.

As a general rule, a bank with more capital is safer than a bank with less capital. But this rule doesn't hold true if the better-capitalized bank is worse at risk management. This is the exception that swallows the rule.

"The week before the run on National City in 2008, we had analysts in our office telling us how safe it was because its capital ratios were higher than ours," the CEO of a major bank recently told me.

National City had to be rescued by PNC Financial (PNC -1.78%) after the federal government refused National City's request for TARP money. And, mind you, regulators were hardly selective when it came to handing out TARP funds, given that the biggest recipients were Citigroup (C -2.90%) and Bank of America (BAC -2.37%).

The table below illustrates why requiring banks to hold more capital isn't the panacea many analysts and commentators presume it to be. It shows the capital positions of some of the nation's biggest banks on the eve of the crisis -- three of which no longer exist.

Bank

Tier 1 Capital Ratio (1Q08)

Tier 1 Capital (1Q08)*

U.S. Bancorp (USB -2.12%)

8.60%

$18,543

JPMorgan Chase

8.30%

$89,600

Wells Fargo

7.92%

$38,211

Citigroup

7.74%

$99,088

PNC Financial

7.70%

$9,007

Bank of America

7.51%

$93,910

Wachovia

7.42%

$45,353

National City

6.67%

$9,548

Washington Mutual

6.40%

$21,560

*Millions of dollars. Data sources: U.S. Bancorp, JPMorgan Chase, Wells Fargo, Citigroup, PNC Financial, Bank of America, Wachovia, and Washington Mutual's 1Q08 quarterly reports.

The thing to note here is the tight range of Tier 1 capital ratios spanning the best capitalized bank, U.S. Bancorp, and the worst capitalized bank, Washington Mutual. We're not talking about a difference of 10 percentage points; we're talking about less than two and a half. This range leaves little room for error, regardless of whether you're talking about the best capitalized bank on the list or the worst. Even small mistakes can render a bank insolvent because of the magnitude of leverage they all employ.

"The banking business is no favorite of ours," wrote Warren Buffett in his 1990 letter to shareholders of Berkshire Hathaway:

When assets are twenty times equity -- a common ratio in this industry -- mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. ... Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

The examples of this are legion. National City was sitting on $20 billion worth of losses from bad mortgages and other troubled loans when it was bought by PNC Financial. Thus, even a double-digit Tier 1 capital ratio wouldn't have staved off failure absent PNC Financial's rescue. By contrast, U.S. Bancorp sailed through the crisis despite the fact that its tier 1 capital ratio was less than two percentage points higher than National City's.

You can see the same thing with Bank of America and Citigroup. Bank of America has incurred $200 billion worth of charges related to the financial crisis, almost all of which can be traced to lax risk management. It failed to do adequate due diligence on its 2008 acquisition of Countrywide Financial. And it incurred tens of billions of dollars' worth of losses from "giving credit cards to people who couldn't afford them," as Bank of America CEO Brian Moynihan acknowledged five years ago.

Meanwhile, between 2008 and 2009, Citigroup recorded $60 billion worth of net operating losses. That may not have rendered it completely insolvent, but it was certainly enough to drop it well below the level regulators consider safe. This is why Citigroup was only able to survive after being bailed out by the federal government.

The point here is that requiring banks to hold more capital is nice, as Dodd-Frank does, but doing so is meaningless without prudent risk management. And the only way you can ascertain this is to look at a bank's past performance. This is why Berkshire holds large positions in U.S. Bancorp and Wells Fargo but avoids the likes of Citigroup and, for all intents and purposes, Bank of America.

John Maxfield owns shares of Bank of America. The Motley Fool owns shares of and recommends Berkshire Hathaway. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Citigroup Inc. Stock Quote
Citigroup Inc.
C
$44.26 (-2.90%) $-1.32
Bank of America Corporation Stock Quote
Bank of America Corporation
BAC
$31.73 (-2.37%) $0.77
The PNC Financial Services Group, Inc. Stock Quote
The PNC Financial Services Group, Inc.
PNC
$151.92 (-1.78%) $-2.75
U.S. Bancorp Stock Quote
U.S. Bancorp
USB
$42.12 (-2.12%) $0.91

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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