Charting Banking XXIII: tangible common equity

by PlanMaestro

More than 3 years after Lehman, I continue to get involved in board discussions over the uses of the tangible common equity (TCE) and its close relative the TCE ratio.

TCE ratio = Tangible Common Equity / Tangible Assets

I am not a fan of using TCE for valuations, very seldom you will encounter a bank going through an orderly liquidation. In good times earnings show and in distressed times, like the ones we live, is precisely when banks can not liquidate orderly. They either,

  1. Survive: and go on to live better times
  2. Dilute: increase capital to navigate bad loan issues
  3. Sell: to a bidder with the balance sheet to navigate the bad loans
  4. Collapse: so who cares about valuation after a wipeout

Surprisingly, most capital raised has been negotiated around TCE multiples, usually close to 1x TCE. To have a future it is first essential to survive the present so capital sets the rules. I will argue though that with credit issues declining fast, current and potential earnings multiples should increase in importance. The age of TCE multiples should and will recede.

The second use of TCE, and the one that I personally use, is the TCE ratio. A measure of leverage and its close cousin: excessive risk taking.

Why the TCE ratio and not all the other capital ratios that regulators use for capital adequacy, like tier 1 leverage, tier 1 capital, total risk? I am old-fashioned, and I think it is important to be skeptic of measures that open opportunities to hybrid capital, that is partly debt, or use “risk” weighted measures of assets, when there are no “safe” assets only safe underwriting. When financial booms come, hand in hand with financial deregulation argued for by the banks themselves, exoteric metrics can easily hide or tempt risk taking.

Leverage is not the only way that banks can take risks, bad loans and investments are even worse. But a risk taking bank will pull all levers and high leverage is a good warning signal. For example, let’s see the TCE ratio for American banks at the bottom of the 2009 crisis.

It does not look like all banks were pushing the envelope but what about the Big 4! Some will argue that these are precisely the banks with high pre-provision profitability to cushion the crisis, with Warren Buffett one of them, and it has some truth.

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they’ve got huge earning power. And Wells … you can’t take away Wells’ customer base. It grows quarter by quarter. And what you make money off is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that’s what they do. (…)

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

Even more, I would argue that this set of banks was not even very responsible for the bubble. Investment banks and other banks that had already collapsed should carry more of the blame.

But add a fizzing real estate bubble to large real estate loan and securities portfolios. Who should you trust with this mounting evidence of too much risk taking? Or as Buffett would say

banking is a very good business unless you do dumb things

So with all the complaining about the new emphasis on the TCE ratio in the dark days of 2009, I wonder … what was new? Banks lobby for deregulation and more leverage only later to complain of regulation “overreach” . The system flatlined only because they asked for the rope to hang themselves.

And let’s not forget that capital for the whole system is important. Capital works as a cushion and help banks to recognize loses faster instead of gambling on a rosier future. To be the lonely good bank, and most were prudent, when the national banking system is collapsing is no consolation. As the Bank of Ireland sadly learned.

The flip side of the TCE ratio is that its improvement also signals banks reducing risk, voluntarily or not, and the progress has been spectacular.

What about Europe? As is public knowledge, European banks have their issues. And it is not just the sovereign debt exposure. Some big banks need capital and the TCE ratio is one if several guidelines that hint on this despite all their complaining.

Does this mean that the American banks are threatened? Good banks but sadly part of a collapsing global banking system?

Not so fast. Retail banking crisis are more of a local/national affair connected to local/national deflation. International assets  are usually not big or risky enough in retail banks balance sheets. But that is an assumption that must be checked, specially with the Big 4 taking more investment banking roles, as we will do in a future Charting Banking.