It compares Basel Tier 1 capital ratios to the tangible leverage ratio using both US GAAP and IFRS – International Financial Reporting Standards – accounting rules. IFRS numbers are particularly interesting when it comes to this comparison, because they bring off-balance sheet derivatives into the balance sheet, painting a more complete picture about a firm’s leverage.
The difference is remarkable, and it says a lot about how misleading Basel standards can be. Wells Fargo has the lowest Tier 1 ratio in the group, but it has much higher tangible leverage ratios, especially when it comes to IFRS accounting rules.
If we measure capital in a “risk adjusted” Basel Tier 1 fashion, both JPMorgan Chase & Co. (NYSE:JPM) and Bank of America Corp (NYSE:BAC) come ahead of Wells Fargo by a small margin, while Citigroup Inc (NYSE:C) and Goldman Sachs Group, Inc. (NYSE:GS) look much safer than Wells Fargo & Co (NYSE:WFC).
When using IFRS tangible leverage, however, things are dramatically different: Wells Fargo & Co (NYSE:WFC)‘s capital levels are roughly double those of its competitors.
There is one big difference when it comes to risk management at Wells Fargo versus its competitors. The bank is well known for its simple approach to the business, avoiding the intricate investments and complex derivatives that practically collapsed the entire financial system during the 2008/2009 credit crisis. Management stewardship is clearly better than at the other banks judging by recent experience, and it´s precisely because of a simple capital allocation strategy – moderate debt levels and easily understandable investments – that Wells Fargo has consolidated its reputation as the safest among the big American players.
Basel Tier 1 ratios include multiple complex assumptions about the possible risks of different kinds of assets. Considering what happened with the credit crisis in the US or, even more recently, with the sovereign debt crisis in Europe, it has become quite clear that past performance is a poor predictor of future results. Not bank managers, nor regulators, have been able to adequately forecast and plan for a crisis scenario, and there is really no reason to believe they will get it right this time.
According to Hoenig, back in 2007 the 10 largest US banks reported Tier 1 capital ratios that, on average, exceeded 7% of “risk weighted” assets. That was believed to be enough by regulators, but it represented an average tangible leverage ratio of only 2.8%. We all know how that ended.
If we want to make sure that the banks are prepared for a crisis, maybe relying on a more straightforward risk measure like tangible leverage is a better idea than putting too much faith in financial models trying to predict the possible behavior of different kinds of assets during a crisis. The Basel III proposal includes leverage ratio requirements, but it calls for it to be only 3%, which has already been proven insufficient in a severe scenario.
It looks like the big US banks, with the notable exception of Wells Fargo, are still exposed to too much risk, even if they meet Basel capital requirements.
The article How Risky Are the Big Banks? originally appeared on Fool.com is written by Andrés Cardenal.
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