The only thing bankers can have felt grateful for this Thanksgiving was a rest. Confidence in subprime-related mortgage products continues to fall. Rating agencies are slashing collateralized-debt obligations (CDOs) faster than you can slaughter turkeys. Analysts at Goldman Sachs reckon that, despite the large write-downs already announced by financial institutions, another $108 billion-worth of losses on subprime CDOs have yet to surface. Adding to the gloom, a $2 trillion source of mortgage funding in Europe, known as the covered-bond market, was temporarily suspended on November 21st because of sliding prices.
All this turmoil is focusing attention on banks’ capital ratios, the amount of money they set aside as a percentage of assets to cover unexpected losses. This cushion is being squashed in a number of ways. First, net losses eat directly into capital. Second, since capital ratios are typically calculated on the basis of how risky a bank’s balance sheet is, the ratings downgrades add to the amount of rainy-day money banks need to set aside. Third, assets are growing as banks take on the financing of more off-balance-sheet vehicles, which again adds to the capital they need.
At some banks, capital ratios are dropping fast. UBS, a Swiss bank, has seen its tier-one ratio (which divides a bank’s risk-weighted assets by its core capital) fall from 12.3% at the end of the second quarter to 10.6%. At Citigroup the tier-one capital dropped to 7.3% in the third quarter, down from 7.9% in the previous one. It remains comfortably above the 6% threshold that American regulators use to define institutions as well capitalised. But as expectations of further write-downs grow, it and others with deteriorating capital ratios will be under pressure to reverse the trend.
There are a number of ways for banks to improve things. They can suspend share buybacks. Or sell non-core assets: Merrill Lynch’s stake in Bloomberg, a financial-information provider, looks eminently disposable. They can cut dividends: expectations are growing that Citigroup will do so. In more extreme cases, they could issue new shares: the bond insurers, which depend on impeccable credit ratings and are important for the health of the banking system, may have no choice but to raise capital. One, French-owned CIFG, has been promised $1.5 billion.
Rights issues and punier dividends would be bad news for shareholders. But the really pernicious effect of capital weakness comes when banks rein in their lending and investment activity in order to keep their capital ratios constant. Back-of-the-envelope calculations from Goldman Sachs suggest that if banks suffer a $200 billion loss on subprime mortgages but want to keep their capital ratios at an average level of 10%, that would stifle lending by a whopping $2 trillion.
Regulators may tighten the screw as well. Confidence in the tier-one capital ratio favored by European regulators seems to have evaporated, says Simon Samuels, an analyst at Citigroup. Investors seem to pay closer attention to more cautious capital measures such as the leverage ratio, which does not allow for any risk-weighted adjustment to assets.
Some regulators may be tempted to take a more conservative approach, perhaps by imposing additional charges on individual banks. They should be wary: banks may need to swerve to avoid a capital crisis; but slamming on the brakes entails dangers of its own.