McKinsey proposes early warning process

MANILA, Philippines - The tangible common equity (TCE) to risk-weighted assets is one of the better predictor of future bank distress, according to McKinsey, one of the world’s leading consulting companies.

In a study, McKinsey explained that the TCE, like Tier 1 capital, could absorb losses as it offers banks the contractual flexibility either to eliminate repayments entirely or to defer them for extended periods of time. It can also absorb losses whether or not a bank remains a going concern.

“Moreover, our analysis found that the measures most commonly regulated currently-those based on the combined Tier 1 plus Tier 2 capital levels-are the least useful, in part because banks can seldom use Tier 2 capital to absorb a loss if they are to continue operating. For example, unrealized gains on securities may be unavailable in times of severe economic stress, and subordinated debt may trigger default if payments are deferred,” it said.

The global consulting firm said that banks have successfully arbitraged capital ratios traditionally watched by regulators through the banks’ increasing use of non-common-equity instruments, such as cumulative preferred stock and trust-preferred securities, that qualify for treatment as Tier 1 capital but could be issued at lower cost than common equity.

“This practice weakens the ability of an institution to absorb losses and the ability of regulations to limit its riskiness,” the study noted.

The firm said that additional leverage ratio would not have offered any insight into the likelihood of bank distress beyond that provided by the TCE/RWA ratio. The same number of banks is affected (and the same amount of distress avoided) whether or not limits are placed on leverage.

“This finding does not prove that regulating leverage ratios is a bad idea. It does suggest, however, that the rationale must be based on other considerations,” it added.

For example, leverage ratios might protect the liability side of the balance sheet against greater-than-expected haircuts on repurchase (or repo) financing, which could precipitate a systemic crisis. It may help prevent future errors in risk weighting and regulatory arbitrage of risk weightings.

But the use of leverage ratios has also arguably created an incentive for the growth of off-balance-sheet activities, which remove certain assets from the leverage ratio calculation and increase risk while circumventing additional capital requirements, it added.

Meanwhile, McKinsey said that while it is possible to lower a bank’s level of risk by increasing its TCE/RWA ratio, the trade-off is higher costs.

“Reducing the number of banks at risk through a higher capital base decreases the returns on equity (ROE) for the industry. For instance, a TCE/RWA ratio of 10 percent would have affected all of the banks that became distressed during the recent crisis but would have required an incremental $1.45 trillion in capital and reduced industry-wide average ROEs by an extraordinarily high 560 basis points,” McKinsey said in the report.

Also increasing the required capital levels would likely have macroeconomic costs, including the effects of a short-term contraction in the availability of credit and the potential long-term effects of reduced lending levels, which result in lower gross domestic product growth.

Regulators could balance the incremental benefits of higher capital requirements against the costs imposed on financial institutions, borrowers, and society more broadly to test the proper ratios.

“For example, our analysis indicates that requiring banks to hold a TCE/RWA ratio in the range of 6.5 to 7.5 percent would have affected 83 percent of banks that became distressed while requiring $540 billion in incremental capital and a decrease in ROE of 260 basis points,” the McKinsey report added.