Meet the Author

William Bednar |

Senior Research Analyst

William Bednar

William Bednar is a senior research analyst in the Research Department of the Federal Reserve Bank of Cleveland. His work primarily focuses on banking and financial markets, macroeconomics, and monetary policy.

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Meet the Author

Mahmoud Elamin |

Research Economist

Mahmoud Elamin

Mahmoud Elamin is a research economist in the Research Department. He is primarily interested in applied theory, game theory, financial economics, and banking. His current work focuses on credit rating agencies, reputation, and regulation.

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01.08.13

Economic Trends

Bank-Holding Companies and Changing Capital Ratios

William Bednar and Mahmoud Elamin

The last financial crisis serves as a clear reminder of the importance of having a banking sector that can withstand a downturn in the economy or a drop in the value of its assets. One of the best protections from such a downturn is capital. Generally speaking , capital is what remains when bank liabilities are subtracted from assets; that is, it’s the difference between what the bank owns and what it owes. Regulators use more precise definitions, and two of these have been steadily improving for bank-holding companies (BHCs) since the financial crisis.

Two standard regulatory measures of capital adequacy are the leverage ratio and the tier 1 risk-based capital ratio. The leverage ratio, or more precisely, the tier 1 leverage ratio, is simply the ratio of tier 1 capital to total assets. The tier 1 risk-based capital ratio is the ratio of tier 1 capital to risk-weighted assets. Tier 1 capital is a regulatory measure of capital that excludes intangibles like goodwill and includes, among other things, the two major components of capital, common stock and perpetual preferred stock. Risk-weighted assets are computed by dividing a bank’s total assets into four categories according to their level of riskiness, then multiplying the value of assets in each group by a risk weight and summing all the groups. The more risky an asset is, the higher the category it falls under. Categories get one of the following risk weights: 0 percent, 20 percent, 50 percent, or 100 percent. For example, cash, which is considered the safest asset, falls under the 0 percent risk-weight category, while unsecured commercial loans fall under the 100 percent category.

We divide BHCs with assets above $500 million into three groups based on the size of their assets.The first group includes BHCs in the top first percentile in terms of asset size, the second group contains banks with assets between the second and 50th percentiles, and the third group is the bottom 50th percentile. We analyze the average leverage ratio and the average tier 1 risk-based capital ratio of each of these groups.

The average tier 1 risk-based capital ratio for the biggest BHCs (top 1 percent) stayed steady with a slight upward trend up to 2005, after which it deteriorated, bottoming out in the crisis, and reversing course afterwards. A clear increasing trend can be seen since 2009. Medium and small BHCs (2 percent to 50 percent percentiles and 51 percent to 100 percent percentiles) saw only a slow decline before the crisis and a sharp reversal afterwards. The average ratios for both have been trending up since then.

We break each ratio down into its components to understand the factors that are causing this upward trend after the crisis. For the largest BHCs, tier 1 capital has almost tripled since 2001. The crisis shows a particular uptick in the average tier 1 capital of these banks. The trend seems to be flattening recently. On the other hand, we see an increase in risk-weighted assets up to the crisis, with a slight drop afterwards and the trend steadying since then. We conclude that the uptick in the average tier 1 capital ratio during and after the crisis is due to an increase in tier 1 capital.

The leverage ratio for the largest BHCs appears to have fluctuated slightly in the last decade, dropping slightly up to the crisis and reversing course afterwards. But when we look at the ratio of risk-weighted assets to total assets, we see a decline up to the crisis and a steepening of the decline after the crisis until it bottoms out around 2010. There does seem to be a slightly subdued upward trend since 2010. If we assume  that the regulatory weighting of assets serves as a proxy of actual asset riskiness, this shows that the average riskiness of the largest banks’ portfolios went down until it bottomed out in 2010, with only a slight reversal afterwards.

Medium-sized BHCs’ risk-weighted assets rose until they peaked in 2005, and then they dropped and rose to a second peak during the crisis. After the crisis, they declined and then steadied. On the other hand, tier 1 capital was on the rise. Particularly after the crisis, we see that the drop in risk-weighted assets, combined with an increase in tier 1 capital, is what caused the uptick in the average risk-based tier 1 capital ratio that we noted before.

The rise of tier 1 capital is reflected in a rise in the leverage ratio after the crisis. The riskiness of banks’ portfolios, reflected in the ratio of risk-weighted assets to total assets, experienced a sharp rise in the run-up to the crisis, with a sharp drop afterwards. This shows two trends in the way BHCs have managed their capital after the crisis—they are increasing their tier 1 capital, and at the same time, they are decreasing the risk-weightings that regulators assign to it.

The smallest-sized BHCs experienced a smoother path than the medium-sized ones. We see less sharpness in the transitions from one quarter to the next. Risk-weighted assets grew up to the crisis and have declined since. Tier 1 capital has been growing, and the crisis does not seem to have had a significant effect on the trend.

The leverage ratio for the smallest BHCs seems to have held steady all along, while the average asset risk-weighting of their portfolios increased sharply up to the crisis and decreased sharply thereafter.