Setting the Record Straight on Bank Capital

 The AFR report then goes on to state that “depending on the metric of leverage used this loss level is either close to or greater than the current level of loss-absorbing capital held by large U.S. banks,” a statement supported by a endnote located at the back of the report, which cites an estimate of the supplementary leverage ratio of six percent for large banks.

This statement is misleading and incorrect for several reasons.

First, it is incorrect to compare a leverage ratio with a supplementary leverage ratio.  This is a classic apples-to-oranges comparison that is both incorrect and misleading.  The denominator used in the leverage ratio and the IMF report is total assets, while the denominator used in the supplementary leverage ratio is total assets plus an amount related to various off-balance sheet items.  Accordingly, as a matter of pure logic, one cannot directly compare a seven percent loss estimate that is measured relative to total assets with a six percent supplementary leverage ratio.  Such a comparison is akin to comparing a British gallon with a U.S. gallon.  Both measures are termed “gallon,” but the volume of fluid held by each is different (a British gallon is larger).  According to data compiled by the Federal Reserve Bank of New York, the leverage ratio of large banks stood at roughly 8.8 percent in the fourth quarter of 2018 (see Table 1), considerably larger than the seven percent cited in the IMF report.  In dollar terms, large banks maintain $1.4 trillion in Tier 1 capital which is substantially larger than the $885 billion amount cited in the IMF report.

Second, the report somehow erroneously assumes that large banks need to maintain capital sufficient to withstand all of the financial crisis losses in order for the entire banking sector to be appropriately capitalized.  This reasoning is hard to understand and square with the basic fact that the financial crisis was a sector-wide event and that the losses cited in the IMF report represent total, sector-wide, losses.  In the fourth quarter of 2018, the U.S. banking industry maintained over $1.8 trillion in Tier 1 capital and a leverage ratio of over nine percent (see Table 1) which is over twice the IMF report’s $885 billion loss estimate.

Still, even if one only considers Forum members, there is sufficient capital to absorb financial crisis losses.  Specifically, as of the fourth quarter of 2018, Financial Services Forum members maintained $915 billion in Tier 1 capital and a leverage ratio of 8.19 percent (see Table 1).  Accordingly, Forum members alone maintain sufficient capital to absorb all of the financial crisis losses referenced in the IMF report.  This fact is missed in the AFR report because the report erroneously compares a leverage ratio with a supplementary leverage ratio.

To this point, when assessing the capital adequacy of large U.S. banks, one should look to the stress-testing regime.  Erected in response to the financial crisis, the stress tests represent a regulator-driven test of capital adequacy that are specifically designed to assess whether large U.S. banks maintain capital resources sufficient to withstand significant financial stress and continue to lend.  According to these tests, Financial Services Forum members maintain capital levels several times larger than that required to absorb severe losses.  More specifically, and as detailed in Figure 1, Forum member stress losses generally hover around $200 billion while Tier 1 capital has registered roughly between $800 billion and $900 billion over the last several stress test cycles.  What’s more, the stress scenario articulated by regulators has been significantly more severe than the financial crisis itself.  Accordingly, large U.S. banks are clearly capable of lending through economic shocks and downturns.

 The AFR report then goes on to state that “depending on the metric of leverage used this loss level is either close to or greater than the current level of loss-absorbing capital held by large U.S. banks,” a statement supported by a endnote located at the back of the report, which cites an estimate of the supplementary leverage ratio of six percent for large banks.

This statement is misleading and incorrect for several reasons.

First, it is incorrect to compare a leverage ratio with a supplementary leverage ratio.  This is a classic apples-to-oranges comparison that is both incorrect and misleading.  The denominator used in the leverage ratio and the IMF report is total assets, while the denominator used in the supplementary leverage ratio is total assets plus an amount related to various off-balance sheet items.  Accordingly, as a matter of pure logic, one cannot directly compare a seven percent loss estimate that is measured relative to total assets with a six percent supplementary leverage ratio.  Such a comparison is akin to comparing a British gallon with a U.S. gallon.  Both measures are termed “gallon,” but the volume of fluid held by each is different (a British gallon is larger).  According to data compiled by the Federal Reserve Bank of New York, the leverage ratio of large banks stood at roughly 8.8 percent in the fourth quarter of 2018 (see Table 1), considerably larger than the seven percent cited in the IMF report.  In dollar terms, large banks maintain $1.4 trillion in Tier 1 capital which is substantially larger than the $885 billion amount cited in the IMF report.

Second, the report somehow erroneously assumes that large banks need to maintain capital sufficient to withstand all of the financial crisis losses in order for the entire banking sector to be appropriately capitalized.  This reasoning is hard to understand and square with the basic fact that the financial crisis was a sector-wide event and that the losses cited in the IMF report represent total, sector-wide, losses.  In the fourth quarter of 2018, the U.S. banking industry maintained over $1.8 trillion in Tier 1 capital and a leverage ratio of over nine percent (see Table 1) which is over twice the IMF report’s $885 billion loss estimate.

Still, even if one only considers Forum members, there is sufficient capital to absorb financial crisis losses.  Specifically, as of the fourth quarter of 2018, Financial Services Forum members maintained $915 billion in Tier 1 capital and a leverage ratio of 8.19 percent (see Table 1).  Accordingly, Forum members alone maintain sufficient capital to absorb all of the financial crisis losses referenced in the IMF report.  This fact is missed in the AFR report because the report erroneously compares a leverage ratio with a supplementary leverage ratio.

To this point, when assessing the capital adequacy of large U.S. banks, one should look to the stress-testing regime.  Erected in response to the financial crisis, the stress tests represent a regulator-driven test of capital adequacy that are specifically designed to assess whether large U.S. banks maintain capital resources sufficient to withstand significant financial stress and continue to lend.  According to these tests, Financial Services Forum members maintain capital levels several times larger than that required to absorb severe losses.  More specifically, and as detailed in Figure 1, Forum member stress losses generally hover around $200 billion while Tier 1 capital has registered roughly between $800 billion and $900 billion over the last several stress test cycles.  What’s more, the stress scenario articulated by regulators has been significantly more severe than the financial crisis itself.  Accordingly, large U.S. banks are clearly capable of lending through economic shocks and downturns.

Conclusion

A recent report released by AFR incorrectly claimed that the banking sector and large banks in particular do not maintain sufficient capital to withstand financial crisis level losses and continue to lend.  This statement is incorrect because it erroneously compares a leverage ratio with a supplementary leverage ratio.  A clear-eyed review of the facts clearly demonstrates that U.S. banks, and Financial Services Forum members in particular, maintain strong and robust capital levels.  While nobody ever wants to see another financial crisis, and the implications of such an event would clearly be damaging and unwelcome,  America’s banks are clearly well-capitalized and resilient to large macroeconomic shocks.