Thursday, September 22, 2011

Banks squeezed by regulations

Moody's downgraded debt of Bank of America, Citibank and Wells Fargo yesterday, saying the banks may not be too big to fail anymore.

In response Bank of America shares plummeted 7.54% to $6.36, below the $6.99 price before Warren Buffett invested $5 billion in the company in August. The price of bank's shares is also nearly 11% below the exercise level of  warrants granted to Buffett. Fortunately for Mr. Buffett, part of the short-term impact should be reduced by 6% dividend from preferred shares he owns, and the warrants can be exercised anywhere over the 10 year period.

Nevertheless, Moody's action reflects increasing pressure banks both in the U.S. and Europe are facing from new regulations introduced after the crisis of 2008 - mainly Dodd-Frank and Basel III.

The former was conceived as a way to allow safe unwinding of financial institutions without the need of government bail outs. The later increases capital requirements for banks.

According to Basel III, banks should increase their Tier I capital (i.e. common shares + retained earnings) / Risk Weighted Assets ratio to 4% and additionally create a "capital conservation buffer" of 2.5%.

However, there is a significant problem with with the way of calculating Risk Weighted Assets (RWA) under Basel III. The regulations assign no risk to sovereign debt. As a result, European banks that already at least partially implemented Basel III rules, face a difficult situation connected with their holdings of peripheral eurozone bonds.

More conservative way of calculating capital adequacy is to simply divide bank equity by assets. When you use this formula to compare U.S. banks to their European peers, you get quite a scary picture:

Chart: Equity / Assets ratio for selected banks; data as of 2011-06-30 based on Google Finance

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