ANALYSIS:Tier 1 ratios that have been used to measure a firm's financial health are now deemed irrelevant by investors, writes PROINSIAS O'MAHONY.

AMERICA’S BIGGEST banks are about to have their shock absorption qualities tested, with the so-called stress testing of major US institutions beginning today.

Such tests might be superfluous if one was to believe the bankers. Bank of America chief executive Ken Lewis protested last week that it had sufficient capital, while Citigroup’s Vikram Pandit said that it too was “well-capitalised”, possessing a Tier 1 capital ratio that was “among the highest in the industry”.

Regulators agree. Sheila Bair, chairman of the US Federal Deposit Insurance Corporation, said last month that “98 per cent of all banks are well-capitalised”. The US government re-iterated that sentiment on Monday, saying that America’s biggest banks had capital “in excess of the amounts required to be considered well-capitalised”.

Markets disagree, predicting nationalisation for both Citi and Bank of America. Narrow regulatory criteria meant that Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac could all boast of being “well-capitalised” even as the endgame was in sight.

The problem is that the Tier 1 ratios that regulators have long used to measure a firm’s financial health are being discarded as irrelevant by investors, who are increasingly migrating to a more conservative measure – tangible common equity (TCE).

There are many reasons for this. Intangibles such as goodwill and deferred tax assets can count towards Tier 1. Critics note that these cannot be used to pay off a bank’s debts and are of no use in the event of bankruptcy. Tier 1 capital also excludes losses on certain assets – mainly mortgage-backed securities – that are deemed to be temporary.

In a recent quarter, Citigroup excluded $6.2 billion of such losses.

Furthermore, certain hybrid securities that are closer to debt than equity can be used to count towards a firm’s Tier 1 capital – at the end of the third quarter, such securities counted for almost a fifth of Bank of America’s $100 billion in Tier 1 capital.

TCE is a much less fluid measure. Intangibles like goodwill and deferred taxes, which are arguably of little value in times of real trouble, are excluded.

Crucially, when a bank loses money or pays a dividend, it comes from tangible common equity. The fact that US banks have very low levels of TCE explains why they prefer to dwell on Tier 1 levels. Just last month, a Citigroup presentation boasted of the fact that nine of America’s largest banks possessed an average Tier 1 ratio of 10.2 per cent. That’s well above the 6 per cent minimum sought by regulators, and comfortably above the 8.8 per cent figure registered in 2006. The Citi presentation, however, also revealed that the same banks saw their TCE levels shrink from 3.5 per cent to 2.1 per cent during the same period.

Citigroup’s own TCE fell to a low of just 1.5 per cent by the end of last year, which is why its share price has cratered even as its Tier 1 capital has grown.

The US has so far opted to boost banks’ Tier 1 capital by injecting preferred shares into institutions. Preferred stock is often viewed as a form of debt, however, in that the banks must make annual dividend payments in repayment. By straining to make these annual repayments, bank capital levels are further pressurised. Citigroup this week finally accepted the market’s judgment, asking for much of this preferred stock to be converted into common stock to boost its fragile TCE level.

For Citi and other troubled banks, this paucity in tangible equity means that part or even full nationalisation is inevitable.

Friedman Billings Ramsey analyst Paul Miller, who has long been a prominent promoter of TCE as the only measurement worth focusing on, has estimated that US financials need at least $1 trillion in TCE.

“The tendency for banks to hide behind regulatory capital ratios has gotten the banking system into an over-levered position that now must be painfully unwound”, he said.

The government this week said that stress tests would be followed by “high-quality capital” for those that need it. That surely means common equity, implying that a fundamental reappraisal of how bank health is measured is under way.

It also indicates that some form of banking nationalisation is a question of when rather than if.