What Does 9.5% Mean?

By James Kwak

This week, the Federal Reserve approved its final rule setting capital requirements for banks. The rule effectively requires common equity Tier 1 capital of 7 percent of assets (including the “capital conservation buffer”), with a surcharge for systemically important financial institutions that can be as high as 2.5 percent, for a total of 9.5 percent. That sounds like a lot, right?

If it sounds like a lot to you, it’s probably because (a) it’s higher than capital requirements before the financial crisis and (b) the banking lobby has been saying it’s a lot to anyone who will listen. But apart from some people thinking that higher is better and others thinking that lower is better, you rarely get any basis for understanding what the numbers mean.

In school, you learn that a 9.5 percent capital ratio means that a bank can sustain a 9.5 percent fall in the value of its assets before it becomes insolvent. But that’s clearly not true, for multiple reasons. First, if a bank were to report that its capital fell from 9.5 percent of assets to 2 percent of assets, it would fail the next day as all of its short-term creditors pulled out their money in (justifiable) panic. In other words, it’s not clear how much of that capital buffer is really a buffer.

Second, that’s 9.5 percent of risk-weighted assets. We all know what risk-weighting means in theory, but few people have a firm grasp on what it means for the actual numbers. As of September 2012, for example, Goldman Sachs had $949 billion in balance sheet assets, but only about $436 billion in risk-weighted assets—although that would increase to $728 billion under new risk-weighting rules. As an illustration, if risk-weighted assets are only half of actual assets, then a 5 percent drop in asset values would be enough to wipe out a 9.5 percent capital buffer.

Third, and most important, there’s measurement error. As many have noted before, Lehman Brothers had something like 11 percent Tier 1 capital two weeks before it went bankrupt. What this means is that, as Steve Randy Waldman said and as I discussed in an earlier post, “Bank capital cannot be measured.”

Given systemically important financial institutions and imperfect regulations, capital requirements have an important role to play. But we should be setting them with the understanding that banks fail before they run out of capital, capital is difficult to measure, and the errors all come out the same way—in the banks’ favor. In practice, of course, it’s all politics: even if Daniel Tarullo wants higher capital requirements, there’s a limit to what he can get through the Board of Governors, and there’s a limit to what Ben Bernanke thinks he can get while remaining an independent agency. That’s the bottom line to remember—not that our new capital requirements are the outcome of some reasoned discussion about how much capital banks really need to protect the rest of us from their misadventures.

14 thoughts on “What Does 9.5% Mean?

  1. Perhaps the only way to get the banks under control is a living will written as if we’re just about to pull the plug and distribute the organs.

  2. Hello, would you please allow me to put this on my website? If there is no any problem with this, please let me know via my e-mail…

  3. This is a decent post, but it come across as too milquetoast. I don’t think Mr. Kwak actually feels this way but the post reads as “well there’s nothing we can do about it folks, if we’re cornered in the trailer about to get raped by TBTF marauders, we might as well lay back and enjoy it”. And while I have great admiration for Steve Randy Waldman’s writings and consider him to be a top 5 blogger on finance, Waldman sometimes comes across as an apologist for TBTFbankers. To say “bank capital cannot be measured” is nothing other than a rationalization and escape clause for bankers who are irresponsible with depositors/savers money. Bank capital CAN be measured and it can be measured precisely. And why do we have capital ratios?? The capital ratios are there to avoid defaults, depositors loss, investor loss, and taxpayer loss. So you use definitive and conservative measurements for capital. You don’t allow a group dominated by TBTFbankers and political lapdogs of those bankers (here read Basel) to make laws that are nothing more than the gigantic GRAY AREA we have had since Glass-Steagall was torn down by Phil Gramm. All of this so Phil Gramm could spend the rest of his living days (11 years to now) at UBS bank with his hand, wrist, and elbow up his A N A L cavity telling people “I’m vice chairman at UBS bank”. Does anyone know anything constructive Phil Gramm does, other than pic his nose and make fart noises at the American Enterprise Institute???

  4. Right on, Mr. Hertzog, but make no mistake- Mr. Kwak is on the same, righteous page, but he is a gentleman and tries to argue respectfully (even though the powerful have no respect for others). Many of us out here are “madder than h_ll” but we are unsure of what to do (a perfect situation for the powerful, by the way).

  5. I wouldn’t get to worked up about what to do about it. The solution will come from a God that most of these people don’t believe in, and just leave it at that.

  6. Well, to be frank, I think there is just about nothing we can do regarding regulatory solutions. Our representives and the governmental process is, as Kwak and Johnson suggest in “13 Bankers” ideologically and financially captured. I think that is very very unlikely to change until AFTER the next banking crisis and ONLY IF a reformer is elected (with a reform-oriented Congress). The time for leverage was years ago, when the banks were dependant. Instead of using that leverage, they were allowed to get bigger and stronger.

    But we have only to look to Egypt to see that ultimately the people have a choice. We can whine about why “the government,” “the administration,” and “our representatives” won’t stand up to the financial oligarchy or we can do an end-around and divest. Heck, we don’t even need to march on anything to do it. Just divest all investment and deposit accounts from the Big 6 and move to regional and community banks and credit unions. We may not be able to end TBTF but we can render it impotent simply by shrinking the banks ourselves.

    Personally, I do not think that it can be acomplished by anger or rage because not enough people care. But it might be accomplished if enough moderates realized that TBTF is a financial gun pointed at our and our childrens’ heads. Steal from me once, shame on you….

  7. @George Peacock, As a critic of the veracity of meta-data, I still sat up and noticed when the demographics presented stated that 60% of the population on the continent of Africa is under the age of 5.

    No one graduating with a student loan (adjustable interest rates, no less, for perpetual war mongering) will ever be able to tap into the potential of the demographics in Africa by building a toy factory, for instance.

    Remember that commercial – “…we make our money the old-fashioned way, we earn it…”. I guess ARMED ROBBERY is “earning it”….

  8. Farmers in Africa are being herded into concentration camps because there’s gold to be mined under their farm – “rents” from student loans provide the cash for such operations. Everyone has their favorite “toy”.

  9. Speaking of the new world order – can you august and austere economists on this blog full of years of “conversation” explain to me how the “greatest military in the world” spoke through USA AG Holder to proclaim that banks that launder drug cartel cash are “too big to prosecute”?

  10. It’s very easy to make it plain impossible for any bank to SUDDENLY fail. See John Cochrane’s recent WSJ article:


    His system gets rid of the TBTF subsidy, which the 10,000 pages of Dodd-Frank have failed to do.

    Others who have advocated much the same system include Laurence Kotlikoff and this lot:


  11. The socalled Fed, the creature from Jekyll Island does NOT work in the people’s best interests. The Fed is a creation of, and a creature for the advancement of the finance oligarchs and the predatorclass fiends who control both the oligarchs and the socalled Fed.
    All this jibber jabber about massaging percentages and capital requirements and all the predatorclass subterfuge masks the real horrorshow reality of a system that is born of, administered by, and intent on advancing the offshore accounts and other profits of the predatorclass!!!

    What a waste of time and space imagining there will be any legal or mathematic remedy to the grotesque robbing and pillaging of the predatorclass!!!

    Burn it all down! Reset!!! It’s the only option for the 99%.

  12. The post’s sentiment is good, but will regulators enforce reasonable calculations in internal bank models? Without it – and it’s quite doubtful – the tier-1 equity ratio is meaningless. Hence a growing push for a fixed leverage ratio…

  13. Maybe capital ratios are part of the solution. Along with reducing the leverage banks can operate with if TBTF. Separating ordinary banking from casino banking also seems to be a must along with greater transparency of reporting. I would like to see things like dark pools hit on the head or required to report stock by stock who did what either in real time or maybe with a 24 hour delay.

    Intertestingly, now that NatWest in the UK is majority owned by the taxpayer their tv advertising is all about how they can be helpful to consumers and to real businesses. I don;t know whether this is yet a culture change within the consumer part of the bank or just a political change in their advertising approach.

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