Stress test research note from UBS

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ASusilovic

UBS did a research note on bank nationalisation on Monday.

It made some very good points — for instance, the need for orderly resolution in any nationalisations (to avoid triggering a cascade of defaults etc.), but what struck us was this section:Looking at past crises, the eligibility guidelines for the state capital support and ultimately, whether a bank was nationalised or not depended on individual banks’ capital ratios adjusted for additional losses and write-downs and were typically divided into three broad categories

Group 1: banks with an adjusted Tier 1 at 8% or above: no capital support was needed;

Group 2: banks with an adjusted Tier 1 of 4-8%: government capital support was provided;

Group 3: banks with an adjusted Tier 1 below 4%: such banks were nationalised with equity holders wiped out.

For the second group of weak but solvent banks, government capital support was typically provided on condition that participating banks submitted plans for improving profitability (i.e., restructuring, cost reductions, corporate reorganisation), to ensure that the government investment would be recovered.

For the third group of “insolvent” banks, policymakers either chose to winddown the operations of banks that were unviable (i.e., the wrong business models) and/or require the separation of assets into good/bad banks with the stated intention that the good bank would be re-privatised at a future stage.


And they’ve done a very convenient chart of the Tier 1 ratios of US banks at the end of 2008. Click to enlarge.

4869.jpg


Right - only by those Tier 1 measures none of these banks need more capital. They are, in the words of Citigroup CEO Vikram Pandit, “well-capitalised” by the key regulatory measure — Tier 1 — and by UBS’s own analysis of past historical crises criteria. There’s no stress apparent — even as the US government embarks on a $500bn-$1 trillion program of recapitalisation.

The fact that the analysts included tangible common equity (TCE) ratios in the table does however, suggest that they’re perhaps (we think) alluding to the need for more TCE — along the lines of the common stock conversions hinted in the Wall Street Journal yesterday. Here’s what UBS says, anyway.
Given US banks’ current low level of common equity, the eligibility guidelines for stress testing banks’ balance sheets may also need to consider the level of banks’ common equity. Matt O’Connor [UBS’s US bank analyst] highlights that one of the most important ratios for banks could be tangible common equity (TCE) plus loan loss reserves as a percentage of risk weighted assets.

Those TCE ratios being, of course, significantly less than their Tier 1 counterparts - With Citigroup in particular dropping from an 11.8 per cent Tier 1 ratio to a mysterious (worrying?) “N/A” on TCE, in the above UBS table.
 
As part of the plan, Citigroup officials hope to persuade private investors that have bought preferred shares - such as the Government of Singapore Investment Corp., Abu Dhabi Investment Authority and Kuwait Investment Authority - to follow the government’s lead in converting some of those stakes into common stock, according to people familiar with the matter. That would further bolster an obscure but increasingly pivotal measure of banks’ capital known as “tangible common equity,” or TCE.

The TCE measurement, one of several gauges of a bank’s financial strength, gives weight to common shares - thus the interest in converting preferred shares to common stock…

There are at least two catalysts for the recent talks with the government.

First, Citigroup’s shares have fallen to historic lows. That doesn’t pose a direct threat to the company’s stability. But if it spooks customers into pulling their business, that could push the bank toward a dangerous downward spiral.

Second, bank regulators this week will start performing their battery of stress tests at the nation’s largest banks as part of the Obama administration’s industry-bailout plan. As part of those tests, the Federal Reserve is expected to dwell on the TCE measurement as a gauge of bank health, according to people familiar with the matter.

The crisis is triggering a deep re-examination of the way bank health is measured in the U.S. financial system. This complex exercise boils down to calculating various ratios of capital to a bank’s total assets.

Until recently, TCE - essentially a gauge of what common shareholders would get if an institution were dissolved - has been one of the less prominent ways to measure a bank’s vigor. TCE is also among the most conservative measures of financial health.

Bankers and regulators generally prefer to use what is known as “Tier 1″ ratio of a bank’s capital adequacy. It takes into account equity other than common stock. By Tier 1 measurements, most big banks, including Citigroup, appear healthy. Citigroup’s Tier 1 ratio is 11.8%, well above the level needed to be classified as well-capitalized.

By contrast, most banks’ TCE ratios indicate severe weakness. Citigroup’s TCE ratio stood at about 1.5% of assets at Dec. 31, well below the 3% level that investors regard as safe.

The regulators’ new focus on TCE represents an important shift. The government’s recent injections into hundreds of institutions were predicated on the idea that Tier 1 was key. Because the investments weren’t in the form of common stock, they didn’t affect the companies’ TCE ratios.

http://online.wsj.com/article/SB123535148618845005.html?mod=testMod
 
Thank you for that post ASusilovic.

My guesstimate of banks (in that list) in order of weakest to strongest is

C
BAC
FITB
HBAN
RF
MI
STI
ZION
KEY
CMA

MTB
USB
WFC
BBT
PNC
JPM
FHN

have not previously heard of TCB
 
TCE is key, because other bits of Tier 1 capital (hybrids) are only loss-bearing in the event of liquidation. Since liquidation, at least in the cases we're talking about, is a thing of the past, TCE is actually the only proper loss-bearing capital.

The moral of the story is that if you're looking at investing in banks, you better look at TCE/Assets, not Tier 1 capital/Assets.
 
Citigroup Inc. and the U.S. are close to an agreement in which the government will substantially increase its stake in the bank and will demand boardroom changes in return, according to people familiar with the matter.

The deal, expected to be announced Friday morning, is designed to ease jitters about the soundness of one of the world's largest financial institutions. Under terms being finalized late Thursday, the Treasury has agreed to convert some of its current holdings of preferred Citigroup shares into common stock, a move that could better protect shareholders against future losses

As a condition, the government is demanding that the New York company overhaul its board of directors, the people said. Treasury will call for Citigroup's board to be comprised of a majority of independent directors. Chief Executive Vikram Pandit is expected to keep his job under the agreement.

The government will convert its stake only to the extent that Citigroup can persuade private investors such as sovereign wealth funds do so as well, the people said. The Treasury will match private investors' conversions dollar-for-dollar up to $25 billion.

The size of the government's new stake will hinge on how many preferred shares private investors agree to convert into common stock. The Treasury's stake is expected to rise to up to 40% of Citigroup, the people said.

http://online.wsj.com/article/SB123570659457790823.html

Clearly, a step to improve TCE.
 
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