Former Fed Governor Thomas Hoenig Says U.S. Banks Undercapitalized

In another round of "stress" tests last month, the Fed said FDIC Release of Fourth Quarter 2014 Global Capital Index .

For the largest U.S. banking firms, the average tangible equity capital ratio – known inversely as the leverage ratio – is 4.97 percent (column 8). In other words, each dollar of assets is funded with 95 cents of borrowed money.

The largest regional and community banks, shown in the last three rows of column 8, have tangible capital ratios ranging from 7.57 to 8.85 percent. That is, they operate with between 1.5 and 1.7 times more funding from their ownership than G-SIBs do.

“The Global Capital Index illustrates how financial resiliency is still sorely lacking,” Vice Chairman Hoenig said. “The sector of the financial industry with the greatest concentration of assets is the least well capitalized. Plainly put, it operates with the largest amount of borrowed, or as we say, leveraged funding, and thus it is the least well prepared to absorb loss. Yet the primary measure of capital – the risk weighted measure (column 3) -- makes the largest firms appear relatively more stable than they really are. The reality is that with too little owner equity funding individual firms, the industry as a whole also is undercapitalized and should one firm fail, the industry continues to be vulnerable to contagion and systemic crisis. It follows that the lack of adequate tangible capital remains among the greatest impediments to successful bankruptcy and resolution.”

The ratios of Tier I capital to risk-weighted assets for all banks (column 3), largest to smallest, are above 10 percent and some of the largest have ratios of more than 15 percent. “This higher capital ratio is achieved by reducing on-balance sheet assets by a pre-assigned risk weight and excluding off-balance sheet assets, such as derivatives. This measure is misleading and overstates the strength of these firms’ balance sheets. No other industry is allowed to make these kinds of adjustments,” Vice Chairman Hoenig said. “The tangible leverage ratio provides a more accurate measure of assets and risks than the balance sheet reported under either GAAP or Basel.”

Banks Not Well Capitalized

Banks are "well capitalized" in the US only by ignoring derivatives. European banks are "well capitalized" by treating all sovereign debt, including Greece, Spain, Portugal, as if it was risk-free.

The reality is banks are undercapitalized globally.

And although taxpayers were forced to cover losses, they shouldn't have been. The notion that bondholders should never take losses is absurd.

The Fed assumes "derivatives are risk free because they net out". Hoenig doesn't buy that argument and neither do I.

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Written By: Mike (Mish) Shedlock