Some of the world’s largest banks are announcing spring makeovers. Earnings have improved, expenses are lower, and capital ratios are higher. Deutsche Bank (DB) said its first-quarter earnings rose 19 percent and that it had sold almost €3 billion ($4 billion) of new stock.
Deutsche Bank had been one of the most undercapitalized of the large global banks. It now says it’s ahead of schedule—and its peer group—in meeting new capital rules that international regulators agreed would take full effect in 2019.
Warning: The big banks may be in compliance, but that doesn’t mean they are safe or no longer too big to fail.
Under the latest regulatory pact, called Basel III, large global banks’ safest capital, called core Tier 1, must equal 7.5 percent of assets and be predominantly common equity and retained earnings. The catch is that banks are allowed to weight their assets (such as loans to companies and individuals, securities, and office buildings) according to the level of risk they represent. A loan to a government, for example, is considered less risky than a loan to a startup company.
The process of risk-weighting has become vexed. Most banks rely on credit ratings combined with internal mathematical models that try to predict risk levels, based on past performance. As we learned from the recent crisis, mortgage- backed securities were considered low-risk, carried the highest credit ratings, and didn’t require capital.
This brings us back to Deutsche Bank, which reported a core Tier 1 capital ratio of 8.8 percent of risk-weighted assets.
Impressive. But there’s a catch. Deutsche Bank gets to that number with aggressive use of risk-weighting to reduce its assets from €2 trillion—about 56 percent of Germany’s total economic output—to about €325 billion, an 84 percent shrinkage. By comparison, the risk-weighted assets of the world’s largest financial companies equal about 50 percent of their total assets.
To Deutsche Bank’s credit, it just raised almost €3 billion in fresh Tier 1 capital by selling shares. This will bring its core Tier 1 ratio up further, to 9.5 percent. Still, Deutsche Bank’s risk-weighted assets will remain tiny when compared with its total assets, as will its capital.
There’s a better way to judge financial health, called a leverage ratio, which is similar to a capital ratio without the risk weighting. Deutsche Bank’s leverage ratio as of last year’s third quarter was 1.47 percent, the lowest among 28 large global banks, according to calculations by Thomas Hoenig, the vice chairman of the U.S. Federal Deposit Insurance Corp. That means a decline of 1.47 percent in the value of Deutsche Bank’s assets could have left it insolvent.
A growing number of economists recommend that banks have 20 percent equity, without any risk weighting. We agree. Such a requirement wouldn’t harm economies. Far from it: The history of financial crises shows that the greatest damage to economic growth arises when banks become distressed from having borrowed too much.