The rehabilitation of bank capital ratios since the lows reached in late 2008 has proceeded on the strength of a range of interrelated contributions, including government assistance, capital offerings and a return of profits.

Trying to isolate the impact of any one contributor is a thorny exercise.

But one way to illustrate the importance of shrinking balance sheets at both large and small institutions — that is, a smaller numerator rooted in heavy chargeoffs, weak lending activity and sales of portfolios and businesses — is simply to compare history with an alternate reality in which assets held at their peaks and everything else stayed the same (see charts).

Total bank assets reached a high of $13.8 trillion in the fourth quarter of 2008 (two quarters after loans peaked, at $7.9 trillion), according to data from the Federal Deposit Insurance Corp. If they had not fallen, the ratio of industrywide equity to assets would still have climbed 142 basis points, to 10.75%, in the second quarter.

But, in fact, assets shrank 4.5%, to $13.2 trillion, during the same period (including an assimilation of hundreds of billions of loans under new accounting rules for securitizations that dampened the slide), and the equity-to-assets ratio grew by 192 basis points, to 11.25%. (One obvious weakness of the counterfactual case is that capital levels, and the size of offerings, are managed in part with reference to asset levels.)

Tier 1 ratios — or Tier 1 capital to risk-weighted assets — show an even bigger differential as risk-weighted assets have fallen far more sharply than total assets. (To a large degree, loans have been replaced by assets, including cash, with lower risk weights.)

If risk-weighted assets held at their peak of $10 trillion in the second quarter of 2008, the industrywide Tier 1 ratio would have gained 123 basis points to 11.33% in the second quarter this year, or about half the actual gain of 235 basis points, to 12.44%.

If the size of capital cushions is the sole interest, the route taken may not matter, but, in terms of the flow of credit to borrowers, the recent downsizing of balance sheets has been a painful road.


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