Analyse Capitalisation and Leverage of Commercial Banks

As part of series of “Analyse Performance of Commercial Banks“, this article focus on the third area of FACE: Capitalisation and Leverage.

FACE stands for:

Why does analysing capitalisation and leverage of commercial banks so important?

Among all risks, loans are very risky because people could default, pay back Loans late, “disappear”, etc. We must assess whether banks have sufficient equity capital to cover those potential losses due to black swan events. Common equity capital provides a cushion to absorb unreserved, unexpected losses and enable a bank to continue as a going concern and avoid failure.

We use CET 1 Regulatory Capital Ratio as the core metrics because this ratio is reported in many markets and has gained widespread market understanding and use.

Click to learn “What is regulatory capital for?” and “The adequacy of capital to absorb losses – capital adequacy ratios“; Examples of analysis commercial banks: Malayan Banking Berhad (MAYBANK) and Public Bank Berhad (PBBANK).

Core Metric: CET 1 Regulatory Capital Ratio (%)

[CET 1 Capital]/[Risk Weighted Assets] ×100%

The numerator is common equity Tier 1 (CET1) capital and the denominator is risk-weighted assets. Banks will provide this ratio in their financial reports, so we can skip calculation of this ratio.

What does CET 1 Regulatory Capital Ratio (%) tell us?

Components in CET1 Capital Basel III

Tier 1 Capital mostly consists of Shareholders’ Equity, and subtract out Goodwill, Other Intangibles and a few other adjustments.

Click here to learn “The adequacy of capital to absorb losses – capital adequacy ratios“.

This ratio should be higher than the benchmark set by the central bank in respective country. Observing the trend of ratios and doing peer comparison is very important.

To improve this ratio, the following actions can be taken:

  1. Change mix of business to lower weighted assets
  2. Raise capital / issue capital securities.

This ratio can be distorted by the following reasons:

  1. Different weightings of assets
  2. High level of capital securities
  3. Under-reserving problem loans or impaired assets.

Complementary Metric: Tangible Common Equity/Risk-Weighted Assets (%)

[Tangible Common Equity]/[Risk Weighted Assets] ×100%

[Tangible Common Equity]=[Total Shareholders’ Equity]-[Intangible Assets]-[Goodwill]-[Deferred Tax Assets]-[Hybrid Capital]-[Preferred Shares]

The numerator is Tangible Common Equity. The denominator is risk-weighted assets and it is a period-end number rather than an average.

What does Tangible Common Equity/Risk-Weighted Assets (%) tell us?

Asset risk and the need for capital go hand in hand. The greater the risk of unexpected loss, the more capital a bank needs to hold in order to retain the confidence of creditors, which enables the bank to fund itself and to shield bondholders from loss. This measure was the most predictive indicator of failure among a number of other measures, including an unweighted leverage measure.

The higher this ratio is the better. Observing the trend of ratios and doing peer comparison is very important.

To improve this ratio, a bank can raise equity, and reduce dividend (create higher earnings retention). This ratio can be distorted by limited details on capital accounts.

Oher useful ratios and metrics that useful to deep dive into warning signals in capital and leverage of banks

Capital AdequacyRatio and CalculationMeaningWays to Improve RatioRatio Distortions
Tier 1 Capital RatioTier 1 / Risk weighted assetsMost stable (permanent) form of capital at least 50% of total capital.Change mix of business to lower weighted assets
Raise capital / issue capital securities.
Different weightings of assets
High level of capital securities
Under-reserving problem loans or impaired assets.
Regulatory capital (Total Capital Ratio)(Tier 1 + Tier 2 Capital) / Risk weighted assetsSufficient capital base to absorb unexpected losses as defined by Basel committeeLimit asset growth
Asset weightings differ by country
Reduce high risk assets
Deferred tax credits included in equity
Leverage ratioEquity to Gross AssetsThe cushion of shareholders’ funds or pure equity to absorb lossesRaise equity
Sell assets
Restrain dividends
Excessive revaluation in high inflation countries
This ignores relative risk of assets and ignores off balance sheet risks except under Basel III
Dividend payout ratioDividend paid / net incomeAmount of retained profit of the year paid awayPay more to the shareholders
Pay less if you need more capital
May be negative if dividends paid out of previous years’ earnings

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