December 6, 2016    5 minute read

Should One Trust The CET1 Ratio?

A Financial Transformation    December 6, 2016    5 minute read

Should One Trust The CET1 Ratio?

Most of the finance news providers are pointing out the problematic situation of European banks. Many financial institutions (especially the Italian ones) have a big stock of non-performing loans and significant financial issues (like liquidity or capital requirements).

How does one know if their bank is safe? By the latest Basel Committee on banking supervision directive, Basel III, everybody should know the Common Equity Tier 1 (CET1) Ratio, the ratio which included the capital of first quality (Tier1) under the risk-weighted assets (RWA).

Basel III directive for the CET1 ratio set a minimum threshold of 10.50%. Over that level, a bank will be ranked as safe to invest in, or safe for deposits. But, can one be sure of that? Can one base their choice of banks only on that ratio? Not entirely.

Our first event

Explaining The Scenarios

CET1 shows a simplistic scenario of a bank situation and has a small range, leaving more fundamental features, also indicated by the Basel Committee On Banking Supervision, like the two tiers available, TIER1 and TIER2, focusing only on the first, the tier of the best quality. Basel III restricted the capital criteria, the capital elements of bad quality are not included in Tier1. But the additional going concern is subjected to restrictions.

If a bank will get over the 10.50% threshold, made by Common equity of 7%–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal buffer)) and 8.5–11% for TIER1, for the BCBS that bank will be immediately considered deemed safe. The latest stress test showed an obvious underperformance of the less safe banks, like Deutsche Bank or Banca Monte Dei Paschi Di Siena (now in big trouble).

Problems With The Ratio

The first problem with the CET1 ratio arrived from the limits of the Value At Risk (VaR), a measure of the risk of investments, which estimated how much a set of investments might lose, in a normal conditions market and a set period as a day. Value at risk is used by investment banks, funds, and regulators in the financial industry to gauge the amount of assets needed to cover possible losses. But the VaR have limits, VaR is a particular characteristic of the probability distribution of the underlying (VaR is essentially a quantile of a distribution). The losses can beat the Value at Risk valuation in an X% of cases, and one cannot know the value it can assume the % of the Gaussian code.

One can overcome the VaR difficulties using the new Extreme Value Theory, a theory which measures the extreme deviations from the median of distributions of probability. Furthermore, the CET1 ratio doesn’t include non-causality mechanisms, with several limits of practicality to the systematic not expected risks, considering only exogenous and not endogenous, risks; risks which ex post will be more decisive. Equilibrium risk, market risk premiums and liquidity problems can be solved in closed form as functions of aggregate bank capital, and the specific risks can be solved by a portfolio with uncorrelated assets, managing the risks.

Solutions

Anyway, the CET1 isn’t a bad starting point for safety considerations of a bank, but it has to be weighed. For the best use of it, you can:

  • Compare with the main balance sheets ratio, like RGD, ROA, ROE.
  • Compare it with another stability index, which you can find on balance sheets information or in platforms (ex. Bloomberg). The most used are – p/BV: price to book value, a multiple of book value. It is useful where assets are a core driver of earnings such as capital-intensive industries (indirect multiple sheets equal more profits). – Texas Ratio and Index who measure credits problems of particular banks. Texas ratio takes the amount of a bank’s non-performing assets and loans, the formula is (NPL+Real estate owned)/(tangible common equity+loan loss reserves). If too many bank’s loans are NPL (non-performing), the bad loans will erode the bank’s equity cushion and will lead to bank failure. A ratio of more than 100 (or 1:1) is considered a problematic sign, so, the bank needs more capital. For example, an Italy Bank, Ubi Banca, have a CET1 ratio of 13% (over the lowest level of 10.50%) but a Texas ratio of 100%.
  • Finding the rating of the Bank: a rating under the investment grade means accounting and performance problems.

Conclusion

One also has a positive side for the CET1 ratio. In this one can find, for defuse the pro-cyclical effect (unexpected downturn and upturn) the introduction of two fundamental buffers: a conservation buffer, extended to the 2.5% of the RWA. It is designed to ensure that banks build up capital buffers outside periods of stress which can be downturn or upturn, with requirements that are based on simple capital conservation rules. These are further designed to avoid breaches of minimum capital requirements, and a countercyclical capital buffer always extends to the 2.5% of the RWA, a buffer of capital aimed to achieve the broader macroprudential goal of protecting the banks from periods of excess aggregate credit growth (often been associated with the build-up of system-wide risk).

Therefore, if you are going to make deals with a bank remember it’s different from the process for buying a car, with the Bail-In directive included in the European Stability Mechanism (ESM), and because of the present NIRP and ZIRP policies. Investing in a bank deposit have return rates of around zero or below. Imagine a bank that pays negative interest, sounds crazy, but with latest QE policies about inflation the TLTRO measures, one has it (equally in Japan).

So, if a man will call you saying his bank is the safest in the world, using the CET1 ratio to reinforce the idea, you will know what to do: wait for Basel IV.

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