As a longtime banking journalist I probably shouldn't admit this, but until a few months ago I'd barely ever heard the term "tangible common equity." When evaluating the health of a bank, my colleagues and I had always been encouraged by analysts and investors to look at the measures about which regulators care most, such as total risk-based capital and Tier 1 risk-based capital ratios.
Now, though, many in the investment community are saying that the tangible-common-equity-to-total-assets ratio is actually the truest measure of a bank's health because - and this is them talking - it shows just how strong a bank's first line of defense is, without any muddling from such intangibles as goodwill, servicing rights and deferred tax assets. The higher the TCE/TA ratio, the less the banks would have to dig into regulatory capital to cover defaults.
Investors and analysts started paying closer attention to this ratio around the time the Treasury Department began investing in banks, and now much of the industry is obsessed with it. Banks that never before mentioned it in the capital ratio section of earnings announcements are doing so prominently. And the Treasury is floating a proposal to convert government-held preferred shares into common equity, in large part to boost TCE ratios.
Since common equity provides a cushion against credit losses, investors obviously want the TCE ratio to be as high as possible, and they start to get uncomfortable when it falls below 5 percent of assets.
But it's worth noting that several of the nation's largest and, by regulatory capital measures, healthiest banking companies, including Wells Fargo & Co. and PNC Financial Services Group, have ratios of less than 5 percent. And, as an industry expert recently pointed out, Washington Mutual Inc. had a very high TCE ratio on the September day it failed.
Critics say that the TCE ratio can understate or overstate a bank's health because its calculation includes unrealized securities losses, which are inherently volatile. In a recent column, industry analyst Tom Brown wrote that investors' "obsession" with the ratio is misguided because regulators look primarily at traditional capital ratios, and they are the ones who decide which banks survive and which ones don't.
Perhaps, but regulators also have an interest in attracting more private investment into the banking sector. It's investors who decide which stocks to buy, so if TCE matters to them, then it has to matter to regulators. Like it or not.