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.