According to the FDIC, bank capital is a critical foundation for a safe and sound banking system and is intended to absorb losses, promote public confidence, restrict excessive asset growth, and protect depositors and the deposit insurance fund. In essence, bank capital plays a role similar to a speed limit on a neighborhood street, and the regulatory rules and definitions that govern bank capital are just as important as the ratio between “miles” and “hour” that sets that speed limit.
Regulatory capital rules generally measure the ratio between capital and assets to determine whether a bank has sufficient capital to operate in a safe and sound manner. (Implicitly, this approach presumes that asset size is a proxy for risk - which is not always a safe assumption but that’s a different topic for a different day.) To measure the ratio of capital to assets, regulators therefore must define both capital and assets.
Conceptually, those definitions should be simple: capital is the difference between an enterprise’s total assets and its total liabilities. But nothing is ever that simple when bank regulation and accounting come together. It is not hard to identify a list of a bank’s assets and liabilities; the trick is in how to value each. Valuation boils down to two basic frameworks: fair value and historical cost. Fair value is what an independent party would pay for the asset or liabilities, i.e. its current true value. Historical cost anchors reported value to the value when the asset was acquired or liability was assumed, regardless of how that value may have changed in the intervening period of time.
The upside of the fair value approach is obvious: it promises to offer a more accurate and timely picture of capital, of the financial strength of a bank, particularly when there have been significant swings since an asset or liability was put on the books. The downsides of the fair value approach include complexity, difficulty in putting a value on assets that are not regularly bought and sold (like loans), and volatility in the resulting capital ratios.
Existing bank capital rules lean heavily towards the historical cost methodology. That tends to work reasonably well in capturing shifts in loan credit risk (through loan loss reserves) but poorly at capturing shifts in interest rate risk impacting both loans and investment securities (which are relatively easily measurable using fair values, which the capital rules typically ignore). For most past banking crises, which were dominated by credit issues, regulatory capital tracked true risk/strength reasonably well. Unfortunately, a big part of the stress facing the U.S. banking system today is the result of higher rates, not credit. And the capital rules are doing a remarkably poor job of measuring that stress and identifying banks at risk as a result.
The U.S. banking industry as a whole has incurred somewhere between $700 billion and $1 trillion in lost value of assets due to higher interest rates (value of fixed rate loans and securities goes down when interest rates increase). That represents about one-third to one-half of total bank capital before rates increased. The economic losses are real and, indeed, are generally reflected in the tangible common equity disclosures used by many investors to value bank stocks. And yet reported regulatory total risk based capital ratios have barely moved at all, reflecting the fact that the capital rules allow the vast majority of banks to ignore unrealized losses due to interest rates. Despite hundreds of billions in economic losses, according to regulatory capital rules, nothing bad has happened.
In this environment, where interest rate driven losses are a critical factor, the regulatory capital rules are similarly almost worthless when evaluating the strength or weakness of a specific bank. Banks that ended up failing, one might imagine, had to have been among the weakest banks immediately before they failed. Yet, all of the recent banks that failed reported solid levels of regulatory capital right up until the banks were seized by the FDIC. Obviously, those reported amounts of loss absorbing “capital” were a mirage. And it is easy to see why the reported regulatory capital levels did not match economic reality: the publicly disclosed amounts of unrealized losses for each bank materially exceeded the reported amount of regulatory “capital”. So the banks that failed were demonstrably economically insolvent, regardless of the contradictory (and inaccurate) signals generated by regulatory capital rules.
Last Reported Total Regulatory Capital Prior to Failure | Minimum Disclosed Unrealized Losses | “Best Case” Adjusted Capital | |
Silicon Valley | $13.7 billion (16.2%) | $17.7 billion | $(4.0) billion |
First Republic | $19.1 billion (12.6%) | $22.0 billion | $(2.9) billion |
Republic First | $288.5 million (9.6%) | $425.2 million | $(136.7) million |
In this market environment, where once again sharply higher interest rates are a defining challenge for banks, heavy reliance on historical cost accounting creates four basic problems.
First, investors, bankers and supervisors are understandably uncertain about the implications of such large gaps between economic reality and regulatory capital. It seems clear, given regulators failed at least some banks, that unlimited levels of unrealized losses are a serious supervisory concern. But how much is too much? While some economically insolvent banks have been seized by regulators, others continue to operate (though hopefully under strict regulatory supervision). When regulatory capital is adjusted for unrealized losses, we calculate that, as of the end of 2023, there were 33 banks with negative capital (one of which was Republic First) and 162 banks with adjusted capital below the 3% Prompt Corrective Action threshold. Uncertainty regarding supervisory expectations delays potential remedial actions by weakened banks. Raising capital or selling a bank to a strong institution are painful and difficult decisions. When the implications of not taking action are unclear, human nature tends to put off those tough calls.
Second, the purpose of bank capital rules is to ensure that shareholders and management have skin in the game. Those rules largely derive from banking problems that arose the last time the Federal Reserve jacked up interest rates in the 1980s, when hundreds of economically insolvent savings and loans were permitted to continue to operate using federally insured deposits. The resulting moral hazard - “If I get lucky, I reap all of the rewards but if things go poorly (and they often did), the costs shift to the American taxpayers” - made a serious problem a crisis as bad bets on real estate development, junk bonds and other speculative long shots went bad. Failing to address such a severe disconnect between economic reality and regulatory capital rules means that at least some banks face similar perverse incentives to take outsized risks in the hope of digging their way out of a hole. Tight supervision of weakened banks (including those reporting strong levels of regulatory capital) is essential to prevent a repeat of the savings and loan crisis.
Third, the failure of these rules to incorporate unrealized losses reduces the obligation of regulators to take action to resolve challenged banks. The Prompt Corrective Action regime was designed to make clear the consequences of failing to ensure a bank remained sound to regulators and bankers. The regime is explicitly tied to drops in regulatory capital levels. When those regulatory ratios overstate the true financial strength of banks, the regime cannot function as intended.
Finally, unlike in past crises that required waves of FDIC bailouts, today, it appears that private capital can be the answer to the rate-driven unrealized loss problem. The vast majority of banks are solvent even taking into account unrealized losses. To the extent their capital has been economically impaired, incremental private capital is a ready solution to stress in the banking system from higher rates. But potential investors abhor uncertainty like that created by the uneasy disconnect between economic reality and regulatory ratios. If an investor recapitalizes a bank weakened by unrealized losses, will that bank’s similarly weakened competitors be advantaged by not having to absorb the pain of raising capital? If an investor provides enough capital to put the bank back on solid footing (e.g. to levels adjusted for unrealized losses in excess of the 3% Prompt Corrective Action threshold), will regulators ultimately demand even more dilutive capital injections?
So what is a regulator to do?
In the longer run, all three banking agencies should take a hard and fresh look at the treatment of unrealized losses in regulatory capital standards. Bankers may reasonably object that it is hard to manage variability in capital due to market swings; small variability can well be noise, not signal. But beyond some level of materiality, those swings are signal - not noise. The math is simple: material unrealized gains and losses on all types of investment securities should flow through measured regulatory capital.
In the short run, regulators have the ability to address at least some of the uncertainty created by the economic vs regulatory capital disconnect. They can do so through conditions and commentary connected to approvals (e.g. of proposed bank mergers), in speeches and industry forums, and ultimately through the bank-by-bank supervisory process. The clearer the regulatory path ahead is for management and investors, the simpler the regulators’ efforts to navigate these stresses will be.
Cover photo by Etienne Martin
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