The Warm Blanket of “Well-Capitalized” Banks

The nagging questions that still linger are what did regulators know about the financial crisis and when did they know it? More specifically, did regulators “miss” the pending crisis in mid-2008? Did they botch an opportunity to shore up the nation’s banking system, or did they take false comfort in the fact that banks in this nation were “well-capitalized” according to the standards set by Congress, that body of prescient banking expertise?

Perhaps we got a hint of an answer yesterday when the Office of the Comptroller of the Currency released a spin-laden, 92-page treatise on the agency’s successes in its annual report for fiscal year 2008, which ended Sept. 30. Among the claims the OCC makes are:

– “National banks were generally able to absorb the financial shocks …”
– “Capital levels well in excess of regulatory minimums gave banks the flexibility to absorb sizable quantities of assets on their balance sheets when liquidity in the credit and capital markets became constrained.”
– “The administration’s plan to invest capital in, and guarantee the debt to, financial institutions has helped stabilize the market.”
– “Despite the unprecedented nature of these [crises], the OCC anticipated many of them before they occurred and dealt with them once they arrived.”

The disconnection to reality is palpable, save a paragraph on liquidity, written by John C. Dugan, the Comptroller of the Currency (pictured below):

“A number of banks were not as prepared to deal with liquidity strains as they should have been, thinking that their access to funding, even in times of stress, would be much better than it proved to be. I think the regulatory community had that same mis-impression, and a number of us have concluded that our liquidity metrics were not sufficiently robust. We have been working with banks all over the country to improve their liquidity positions. In addition, the Basel Committee issued a very thoughtful paper on liquidity risk management, and we have spent a considerable amount of time developing a better template for gathering data to measure liquidity risk. I believe these efforts will produce real improvement over time.”

How this comports with Dugan’s “Despite the unprecedented nature of these events, the OCC anticipated many of them before they occurred and dealt with them once they arrived” I have no idea.

What I can say, however, is that the OCC apparently saw a much rosier banking industry on Sept. 30 than did other market observers. On Page 75 of the annual report, the OCC offers statistics on the nation’s banking system. In the section entitled “A safe and sound national banking system,” the OCC pegs the “percentage of national banks that are categorized as well-capitalized” at 99%. 99%! In other words, exactly 16.78 banks were not well-capitalized as of Sept. 30, 2008, weeks after the credit markets blew up after Labor Day. And what was the percentage for fiscal year 2007? 99%. Fiscal year 2006? 99%. Fiscal year 2005? Well, you get the idea – 99%. Ah, what a blissful banking world we live in.

The OCC defines a well-capitalized bank as one with a Tier 1 capital ratio of 6% or higher. An OCC spokesman maintains that the data in the annual report was a “precursor to all this activity,” and that is just hard for me to swallow, especially since Dugan writes in the annual report about how in 2008 “large banks that experienced difficulties responded by aggressively raising capital to shore up their balance sheets, attracting well over $100 billion.”

Dugan writes that this was the reason why “virtually all national banks continued to satisfy the definition of ‘well capitalized’ on Sept. 30.” That may be true. The more damning fact is that the definition of “well-capitalized” is a sham, which is all the sadder considering that our regulators use the definition like a baby uses a warm blanket. This must change.