WASHINGTON — A growing reliance on tangible common equity as a gauge of banks' financial condition is a sign that investors have lost faith in regulators' ability to predict and solve problems at financial institutions.
In response to the growing concern that the government is poised to take over several banks, regulators on Monday offered a tacit endorsement of the measurement, saying banks may soon be able to convert their government-owned preferred shares into common equity.
Such a move would boost a bank's tangible common equity, or TCE, ratio, which for most large banks is significantly lower than its Tier 1 capital. Though some observers argue that the ratio is not as good an indicator as regulatory standards, they say that regulators may have no choice: Investors simply do not trust current standards.
"The capital rules have no credibility," said Karen Shaw Petrou, the managing director of Federal Financial Analytics. "That's exactly the problem."
But it is unclear how helpful the measurement is. Some argue it is a better way to look at a bank.
"Tangible common equity is a much more pure and conservative estimate of long-term ability to withstand losses," said Douglas Landy, a partner in Allen & Overy LLP in New York. "Tier 1 includes items that can go away after five years."
But others argue that TCE ignores several important aspects of a bank's balance sheet, including goodwill and reserves.
"No one is suggesting it isn't important, but it's not the only criterion by which to evaluate the financial health of a bank," said Steve Blumenthal, a former deputy director of the Office of Federal Housing Enterprise Oversight. "If you only use TCE, you are not getting an accurate picture of the financial condition of a bank."
The differences between an institution's Tier 1 capital and TCE can appear stark. For example, Citigroup Inc. had an 11.9% Tier 1 capital ratio at Dec. 31, and a 1.5% TCE.
With all the unrest in the market, said Eugene Ludwig, a former comptroller of the currency and now head of Promontory Financial Group, examiners are pressuring banks to raise their Tier 1 capital, even if they are already well capitalized.
"You hear it from banker after banker after banker," he said. "I would not be forcing up capital requirements right now, because we have strong capital standards, and I would certainly not be forcing people above 'well capitalized.' It is procyclical, and it cuts off credit."
Though banking regulators said they plan to start stress tests of banks on Wednesday to better assess institutions' capital adequacy, Mr. Landy said investors' flight from bank stocks in the past week appears to reflect concerns that regulators do not know which banks are healthy. "It's a complicated dance between what the regulators feel is a healthy bank versus what the market feels is a healthy bank," he said. "The market is devaluing the strength of the government investment."
Observers said that the uncertainty reflects how ineffective previous government rescue efforts have been.
"Instead of putting in actual common shareholder equity that is a legitimate buffer against loss, they've messed around with this quasi-capital, and it hasn't fooled the smart people in the market," said Richard Herring, a professor of finance at the University of Pennsylvania's Wharton School.
Prof. Herring said regulatory capital requirements are not the things that really matter to the people doing business with the banks or investing in them. "That's not what counterparties look at; it's not what bank security analysts look at."
Bolder action, taken earlier, might have helped, some said.
"I think it shows you how tricky it is to use half-measures to fix such a significant problem," said Chris Low, the chief economist in New York for First Horizon National Corp.'s FTN Financial Capital Markets in Memphis. "The real issue here isn't so much tangible common equity versus Tier 1; it's government promising a bank rescue and then failing to deliver. If the government's not going to rescue the banks, if all it's going to do is provide reassurance, then investors are going to take things into their own hands."
Joseph Thomas, a managing director at Hovde Private Equity Advisors in Washington, said investors look at the market value of a bank as a proxy for its tangible common equity. "Today, the market value of the equity as observed in the stock price for many banks is well below the current book equity," he explained, "and the reason for that is, the loan-loss provision is not substantial enough to reflect the embedded losses in the banks' balance sheet[s]."
Some observers reasoned that, if market participants had a clearer understanding of which banks faced the biggest losses, they would not have to focus so heavily on tangible common equity.
With greater transparency, investors could figure out where their money would grow safely and where it would be lost in an eventual, drastic rescue effort by the government. Private investors would also be able to better assess which investments to make and at what price. "The challenge is that, when a bank actually recognizes losses through its income statement, which shows up as provisions for loan losses, that first hits tangible common equity, and in many banks it's driving that to zero," Mr. Thomas said.
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Corrected March 10, 2009 at 5:35PM: An earlier version of the chart with this story showed tangible common equity ratios at 10 large banking companies. SNL Financial, the source of the data, calculated the ratio as a percentage of total assets, but some firms view risk-weighted assets as a better denominator. SNL has provided a new chart using that ratio.