During the credit crisis, Bank of America Corp. symbolized everything that was wrong with banking: a too-big-to-fail global bank with questionable acquisitions (Countrywide and Merrill Lynch), poor lending standards, and poor liquidity and capital management – one that received capital injections from the government time and again.
Regulators and legislators must have had B of A in the back of their minds while crafting a new regulatory framework for banks in the form of Basel III and Dodd-Frank.
Astonishingly, it appears that B of A does not understand the role it played in the crisis.
Late last month, tucked away in its presentation describing $18 billion in second-quarter mortgage-related charges, management disclosed its objective for meeting the requirements of the new regulatory regime: “Assuming no benefit for the Basel III capital deduction phase-in (i.e. fully front loaded basis), our goal is to achieve a 6.75% - 7% Tier 1 Common Ratio by 1/1/13.”
Come again? The largest bank holding company by assets in the United States, with operations spanning the globe, is shooting for only 6.75% to 7% of Basel III Tier 1 common equity?
And that’s not even a forecast. It’s just a “goal” – an alarmingly modest one which should be worrisome for regulators and investors.
From a regulatory perspective, the analysis is straightforward. Basel III requires banks to hold 7% of risk weighted assets as Tier 1 common equity, made up of a 4.5% minimum and a 2.5% capital conservation buffer. Last month the Basel Committee added a surcharge of 1% to 2.5%, made up of Tier 1 common equity, for global, systemically important banks. With a balance sheet of more than $2.2 trillion, B of A will have to hold 9.5% Tier 1 common equity at an absolute minimum by 2019.
Further, it’s hard to imagine regulators will allow banks to operate at the minimum levels. More likely, banks will be nudged to hold a “voluntary” buffer above and beyond the baseline 9.5%. It is safe to assume that this buffer will consist of another 1% of common equity – 10.5% in all. So at the very least, B of A has a 3.5% Tier 1 common equity shortfall.
B of A itself projects that its risk-weighted assets under the Basel III framework will jump to $1.8 trillion from the current $1.4 trillion under Basel I. Assuming the 10.5% requirement, B of A will need to hold close to $190 billion of common equity after regulatory deductions. As of March 31, B of A had Tier 1 common capital of $123.9 billion – a shortfall of $66 billion.
The central question that should concern investors is where this additional $66 billion of common equity will come from. B of A has not executed a major equity offering in some time, and with the stock trading at 0.8 times the bank’s tangible book value, the board may decide that an offering is too dilutive right now for shareholders. Not only does B of A have to worry about this shortfall, the company also has more than $21 billion of trust preferred securities and $16 billion of preferred stock which have to be managed. Basel III and Dodd-Frank disqualify Trups from Tier 1 capital and the future regulatory treatment of preferred stock remains unclear.
To be fair, Bank of America’s target assumes that it will take upfront a capital hit that, in reality, can be recognized over time. Basel III caps how much assets like mortgage servicing rights and deferred tax assets may count toward capital, but the deductions can be phased in over four years, beginning in 2014. B of A didn’t take this flexibility into account in setting its 6.75%-7% goal for 2013. Given the $15 billion in MSRs and $12 billion in DTAs that B of A held as of March 31, the ability to phase in deductions should help the bank manage its challenging capital position.
Still, market participants and the various regulatory bodies overseeing banks are seeking compliance with Basel III sooner rather than later. No bank capital management team will be allowed to dawdle until 2018 or 2019.
The clearest indication of this for B of A is the Fed’s rejection of the company’s capital plans, including a proposed increase in dividend distributions, following the 2011 stress tests (an exercise that was formally known as the Comprehensive Capital Analysis and Review). A key benchmark in that exercise was for banks to meet the target level of 7% Tier 1 common capital under Basel III – a daunting task for B of A.
B of A management must lay out a clear roadmap for achieving its future capital requirements. It is hard to envision a scenario where a large common equity offering is not involved. Realizing gains by retiring non-compliant capital instruments at a discount, no matter how modest those gains might be, is another potential avenue for capital generation. Lastly, the strategy for raising the Tier 1 common equity ratio cannot rely on capital in the numerator alone. B of A needs to efficiently manage risk-weighted assets in the denominator as well. The focus of this effort should be on businesses that require significant capital under Basel III, such as over-the-counter derivatives with counterparty credit risk.
A comprehensive capital management plan that includes all of these elements will ensure B of A does not repeat its mistakes in any future crisis.
Michael Shemi is a director at Christofferson, Robb & Co., a money management firm with offices in New York and London.