Bank of America's Capital Perception Problem
Bank of America may not understand its capital problem, at least from an investor viewpoint.
After listening to Brian Moynihan, the bank's chief executive, talk about his bank's capital position over the last few days, I've come to the conclusion that the senior management of Bank of America just doesn't fully understand the role capital plays in banking.
Moynihan points out that the bank is in a far stronger capital position than it has ever been in its history. Bank of America has $153 billion in Tier 1 capital and $1.393 trillion in risk weighted assets, which gives it a Tier 1 capital ratio of 11 percent. That's well above any regulatory requirements that currently apply. Moynihan says Bank of America will have a fully compliant Basel III Tier 1 common equity ratio of 6.75 percent to 7 percent by the end of 2012, six years ahead of the deadline. Even if regulators impose additional Too Big To Fail capital requirements, the bank should be able to meet them without having to have a dilutive round of equity sales.
This is how bankers like to think about capital, as a requirement set by regulators. Once they meet those requirements, they would like it if investors and counterparties just stopped asking about capital.
The bankers tend to think that the only reason they should ever have to raise new capital would be if regulators pushed them to do it. So the only time investors should worry about capital is if they are in danger of dilution.
But investors and counterparties are not required to accept regulatory capital settings. In particular if investors are worried that a bank prospects are dim, they may require additional capital to guard against insolvency.
Pragmatically speaking all banks are in danger of insolvency for the very simple reason that their liabilities are much greater than their capital assets. But most banks run a risk of insolvency that, according to their internal models, is never greater 0.5 percent in any year.
If investors become convinced that a bank's risk of insolvency is higher than it should be, they are likely to demand a premium to bear this risk. Banks can meet this demand with higher dividends. But Bank of America is dividend constrained due to its under-performance on government stress tests. So investors concerned about risk sell the stock. The stock falls to the level at which investors perceive that they are being compensated for the added insolvency risk.
Because shareholders discount banks for perceived riskiness, bank capital is not as expensive as it is often thought to be. A bank that adds capital lowers its risk profile, which means that the risk premium diminishes. It's possible that some banks may be far enough out on the risk curve that a highly dilutive capital raise would not diminish their share price. Shareholders would have diminished stakes in the company, but those stakes would be less at risk from insolvency. Think of it as a Laffer Curve for banks.
We see this quite frequently in banking. When Lehman Brothers had a secondary offering in the spring of 2008, its shares rallied despite the dilution. Part of this may have been psychological. But part of it was probably also the perception that Lehman was reducing its insolvency risk by raising capital.
The market value of Bank of America's equity was $71 billion as of Thursday morning. That's just over a third of its book value. This implies that there is risk discounting going on, which should be a signal for the bank to raise capital. I'm not arguing that shareholders believe that Bank of America is about to go under—if that were the case the bank's shares would quickly race toward zero.
It's more subtle than that. The deep discount to book value implies just some perceived risk of insolvency above the ordinary 0.5 percent.
In short, market capital requirements increase in response to a rise in the expected costs of financial distress. Bank of America's stock price is an indicator that it is not meeting the capital requirements of the market.
But the senior management of Bank of America doesn't view capital that way. They view it through the lens of regulators. Until they can see their capital through the eyes of investors, they will continue to be baffled by their share price.
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