Investors in the largest U.S. banks were not thrilled with news that the Federal Reserve is working on capital requirements that are stricter than the requirements laid out under Basel III norms, as evidenced by the KBW Bank Index sliding 1% on Tuesday, September 9. Morgan Stanley’s shares fell the most (2.7%), owing to reports that banks with a larger dependence on short term funding are likely to attract a higher capital surcharge. Investment banks Goldman Sachs and Morgan Stanley rely heavily on overnight loans for their day-to-day operations, with such loans accounting for almost 40% of their total funding sources. Higher common equity tier 1 (CET1) ratio requirements will force the banks affected to take a harder look at their business models to find ways to shrink their balance sheets. The banks will also have to cut down on their capital return plans, and may even have to issue more shares to make up for any capital shortfall.

While the proposed increase in capital requirements is definitely not good news for the banks, how well do these banks fare in terms of existing Basel III requirements? In this article, we highlight the degree to which the six largest U.S. banks have improved their Tier I common capital ratios over the last seven quarters. While some of them have surpassed requirements comfortably, some have barely made the mark and are expected to continue to shore up their capital over the next few quarters.

In the wake of the global economic downturn of 2008, financial regulators around the world have been working on tighter rules to ensure the sustainability of global banks in the event that such circumstances repeat in the future. The Basel III standards formulated by the Basel Committee on Banking Supervision form the crux of the proposed financial sector reforms, with banking industry regulators for each country implementing additional controls beyond those laid out under these standards. As a consequence, banks around the globe have diligently worked to meet the stringent guidelines, even though the standards themselves have not yet been finalized. Notably, the common equity Tier I (CET1) capital ratios are most often used as a quick reference to gauge a bank’s capital strength and also to compare them side-by-side. This is the figure we tabulate below to allow for the comparison of the country’s biggest banks.

The figures below have been taken from the quarterly filings for each of the banks since Q3 2012 (the period for which data is available for all the banks) and refer to the pro-forma fully phased-in CET1 ratio figure they report. It should be noted that some of the banks revise the Tier I common capital ratios from time-to-time retrospectively, to account for ongoing modifications in the Basel III standards. Also, the CET1 figure for some of the banks fell by as much as 40 basis points (0.4%) between Q4 2013 and Q1 2014 due to a change in the way the size of risk-weighed assets was calculated for these banks, as they adopted the new valuation guidelines proposed under Basel III. The table also includes the CET1 ratio target regulators have set for each of these banks. These are different for each of the banks based on their complexity, global footprint as well as interdependence (see The Basel III Challenge For Banks: Why Extra Capital Requirements?). Finally, the buffer mentioned here is the difference between the target and the bank’s CET1 ratio at the end of Q2 2014.

	Q3 2012	Q4 2012	Q1 2013	Q2 2013	Q3 2013	Q4 2013	Q1 2014	Q2 2014		TARGET	BUFFER
Morgan Stanley	9.00%	9.50%	9.70%	9.90%	10.80%	10.50%	10.20%	10.70%		8.50%	2.20%
Citigroup	8.64%	8.74%	9.34%	10.03%	10.50%	10.59%	10.46%	10.58%		9.00%	1.58%
Wells Fargo	8.01%	8.18%	8.39%	8.55%	9.54%	9.78%	10.04%	10.09%		8.00%	2.09%
Bank of America	8.97%	9.25%	9.52%	9.60%	9.94%	9.96%	9.56%	9.89%		8.50%	1.39%
Goldman Sachs	8.50%	8.80%	9.00%	9.30%	9.80%	9.79%	9.72%	9.84%		8.50%	1.34%
JPMorgan	8.38%	8.74%	8.86%	9.33%	9.33%	9.50%	9.58%	9.79%		9.50%	0.29%

Morgan Stanley leads the U.S. banking giants with a CET1 figure of 10.7% at the end of Q2 2014 – a considerable effort, considering that the banking group has improved the figure by almost two percentage points within seven quarters. The ratio has benefited from the investment bank’s decision to remain stingy with returning cash to shareholders – instead focusing on acquiring 100% of Smith Barney from Citigroup over the last two years. Morgan Stanley’s long term strategy of cutting down on the capital-intensive fixed-income trading business has also helped reduce the size of its risk-weighed assets, which in turn has given the CET1 figure a boost. The bank also ranks at the top in terms of achieving the highest capital buffer over and above the mandatory target set for it by regulators. Morgan Stanley’s CET1 figure at the end of Q2 2014 is a good 220 basis points (2.2% points) higher than its target of 8.5% that needs to be achieved by 2019. Notably, this means that the investment bank will not have to worry too much about working on its capital ratios even if the Fed decides to impose an additional 2% capital surcharge on the bank for reasons detailed above.

Citigroup comes in at a close second with a CET1 figure of just under 10.6%. The bank’s decision to shift non-performing and non-core assets into the umbrella Citi Holdings division in 2009 and to subsequently divest them has paid off quite well. This has helped the bank systematically reduce the size of its risk-weighed asset base, which forms the denominator in the calculation of the core Tier I capital ratio.

JPMorgan stands out as the only bank that has barely achieved its capital requirement target, with all the others shoring up capital enough over the last couple of years to beat Basel III requirements by at least 130 basis points (1.3%). As the bank is not expected to make any major changes to its business model, it clearly intends to build its tier 1 capital gradually over the coming quarters by relying on its strong earnings figures.

Bail-in Example – How Your Money will be Confiscated Scenario: Let’s assume Bank of America is in a precarious financial situation. Given the new resolution policy of Bail-In, how would your cash accounts at big banks be affected? Can you still get cash to pay your bills?
Event Reactions, Consequences How, Why, Comments
JP Morgan Chase loans Bank of America money.
• JP Morgan Chase notices that BofA has been making some bad moves lately and decides to hedge against the risk of BofA not repaying their debt to Chase by purchasing a credit default swap derivative on BofA debt.
• With BofA not looking so good, Chase also bets on a decline in value of BofA stock through a short sale.
• The credit default swap would pay Chase if BofA failed to repay their loan.
• When an investor goes short on an investment, it means that he or she has bought a stock believing its price will go down in the future and they can make money on that bet.
Chase lets other hedge funds know they are shorting BofA.
• Other hedge funds short BofA stock. • At this point, any action that Chase might take to boost the odds that BofA would default will increase the value of their derivatives. That possibility might tempt Chase to take actions that would boost the odds of failure for BofA.
The hedge funds shorting BofA pull their money out of BofA.
• BofA starts to have Capital Requirements problems. In a snowball effect, other financial groups start pulling their money out of BofA too.
• This kind of behavior in which hedge funds pull their money out of banks whose stock they are shorting contributed to the failures of Bear Stearns and Lehman Brothers.
BofA is failing.
• Chase and all the other big banks want to cash-in their derivative contracts with BofA.
• BofA assets are rapidly depleted.
• Normally when a bank is failing the FDIC would have the powers as “trustee in receivership” to protect the bank’s collateral and bring about an orderly resolution of assets. The proceeds would then be used to pay depositors with the difference being made up by the FDIC. However, the FDIC’s powers are overridden by the special status of derivatives given to the big banks by the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act.
• The FDIC cannot intervene and must wait till the big banks holding derivative contracts with BofA get all their money back regardless of the assets affected. This includes individual depositor accounts and state/local government accounts.
BofA cash is transferred to other banks in payment for derivative contracts.
• BofA is drained of assets, including individual depositor accounts and state/local government accounts.
• All cash is gone at BofA leaving only real estate assets.
• All this happens in one night in the “overnight sweeps” process.
• One day a depositor will have money in his/her account and the very next day there will only be an empty asset IOU entry.
FDIC comes into BofA to resolve the failure.
• A new company is formed to manage the remaining assets of BofA.
• Depositor asset IOU’s are converted into stock in the new company.
• The FDIC executes the new Bail-In policy laid out in the December 2012 document, Resolving Globally Active, Systemically Important, Financial Institutions
A BofA customer comes into the bank to get cash to pay bills.
• When asking for a withdrawal the person is given a share of stock in the new company but no cash.
• The FDIC is no longer responsible for your account and is not required to give you cash. Why? Because the FDIC only insures cash accounts not equity accounts and your account has been converted to equity (stock) from cash.
• It is the customer’s responsibility to get that share of stock converted to cash. Of course, since the new company was formed from a failed bank in the first place, it may be difficult to sell it, much less get remuneration equal to the cash lost when the bank failed and Bail-In was executed.