They Can Do the Math, and You Can’t

Battles rage between shareholder money and taxpayer money in the arena of Too Big To Fail bank capital ratios. The biggest banks make capital dodging an artform.

Big bank credit rating downgrades are likely to continue and will make demands on bank capital. Taxpayers should be concerned about the adequacy of capital, as captured in capital ratios. The problem is that nobody follows these calculations except regulators or maybe bank analysts. However, the issue is starting to capture the attention of the media.

Capital in this case is comprised of financial resources that could be used for a variety of purposes — to make loans, to support derivatives exposures, to set aside as reserves. It’s the latter that the biggest banks dislike. They don’t earn money on reserves set aside to back risk. Regulators are trying to force them to build up reserves to avoid the need for future bank bailouts.

Credit ratings affect capital requirements in two prominent, but lesser-known ways. Most people understand that borrowers with poorer credit ratings pay a higher interest rate to account for the higher risk. Less well known, derivatives contracts contain clauses that require a counterparty to post collateral, usually cash, in the event its credit rating is lowered. The collateral protects the party on the other side of the contract as the contracts may have very long tenors — longer than five years in many cases. An article by TomBraithwaite, Tracy Alloway and Shahien Nasiripour in today’s Financial Times points out that a downgrade may cost Morgan Stanley an additional $9.6 billion  in collateral calls.

Even murkier is the impact of credit rating downgrades on the measurement of exposures, which also increase the amount of capital required by regulators. Someone with decent math skills may find the basics of how regulators calculate bank capital easy to understand.

Bank capital adequacy is measured as a ratio, expressed as a percentage — the amount of bank capital that supports the risks it takes.

The numerator is the amount of capital raised by the bank. Regulators tightened these requirements after the meltdown. The strongest form of capital is common equity.

The denominator is the sum of the risks taken by the bank. It has two primary components: the risks ON the balance sheet and the risks OFF the balance sheet. Where the bank has money out the door already, such as in the case of a loan, the risk is shown ON the balance sheet. Risks that are OFF the balance sheet include transactions involving future performance or events. These include contractual promises to make loans in the future (called commitments) and derivatives transactions.

Derivatives like most measured exposures are risk-adjusted. If the counterparty is a highly-rated food company or a highly-rated country, a smaller percentage of the exposure would be included in the denominator than were the counterparty a low-rated credit. Exposures to lower-rated borrowers are included at 100% in the case of loans.

Basel regulatory guidelines require derivatives to be placed into three possible “buckets,” or categories — zero percent, 20% and 50%. (There is no 100% for derivatives, unlike loans.) Key to understanding the implications of credit rating downgrades on capital requirements is understanding how these buckets function.

The 20% bucket is where the bank includes derivatives to counterparties rated A- (by S&P) or A3 (by Moody’s) or better. The Fed until recently has assured the rating agency of government support so that the biggest banks’ credit ratings have remained above these rating levels. However, the rating agencies not only talk to Fed staff, but also read the same newspapers and media that the public sees. The intent of Congress in Dodd-Frank and the mood of the country make substantial government bailouts of these largest banks much less likely, or at least much less politically supportable. So the rating agencies are lowering their assumptions of government support from their credit rating assessments. Ratings are declining.

The largest banks dominate derivatives, so when the credit ratings of a few decline below the A-/A3 threshold, their counterparties must move those derivative contracts into the 50% bucket. Instead of having to include 20% of the exposure in the denominator, the bank would have to include 50% of the same number. The denominator increases, and the capital ratio declines. Even a bank that didn’t suffer a credit rating downgrade may have to raise additional capital. Their risk grew because their counterparty is a weaker credit now. If a bank doesn’t raise the needed additional capital, it is the taxpayer who stands behind this risk.

The Fed is helping some more favored banks play this game of capital dodge-ball as described in our earlier post. The credit rating of an FDIC-guaranteed bank is one or two rating “notches” higher than the credit rating of its holding company. When the Fed allows bank holding companies to move their derivatives contracts into the FDIC-guaranteed bank, it is helping the bank’s counterparties access a better-quality credit — and saving some capital. The Fed has overridden the FDIC, as noted in an October 2011 Bloomberg article by Bob Ivry, Hugh Son and Christine Harper, in the case of Bank of America and its Merrill Lynch subsidiary.

There are so many issues here for U.S. citizens — additional bailouts of big banks, the lack of evenhandedness on the part of the Fed and government policy behind the FDIC guarantee. Congressmen, are you doing your math?