Rewriting the Rule Book for Bank Stocks

By PETER EAVIS Bad times are worse when it looks like the rule book has been thrown out the window. That's one reason bank stocks may find it hard to rally from bombed-out levels in 2009. As the weakening economy weighs on financial shares, extra uncertainty has been created by the spectacle of regulators seizing banks or forcing punitive rescues, even when the banks appeared well-capitalized. Seeing this, bank-stock investors can reach one of two conclusions, neither reassuring. Either established capital measures don't fully capture banks' weaknesses -- before its seizure in September Washington Mutual had a Tier 1 capital ratio of 8.4%, well above the level necessary to be called well-capitalized -- or the regulators themselves are flawed, pushing for drastic action at banks that may have had enough capital to find less-destabilizing solutions to their problems. Associated PressFor instance, National City Corp., which agreed to sell out to PNC Financial Services at a rock-bottom price in October, had a Tier 1 capital ratio of 11% at the end of September. That's much higher than J.P. Morgan Chase's 8.9% and the 7.6% at Bank of America at the end of the third quarter. Wachovia, which agreed in October to sell out to Wells Fargo, had a third-quarter Tier 1 ratio of 7.5%, significantly above the 6% threshold regulators use to classify a bank as well-capitalized. Against this chaotic backdrop, regulators are working to reform bank regulations and are looking closely at capital, which acts as a buffer against losses. But isn't clear yet whether they are willing to make the sort of big changes that would boost investor confidence. One key area that needs reform is how banks manage their liquidity. Banks can have high capital ratios at the same time as funding sources start drying up -- a factor that helped prompt recent regulatory actions. In a securities filing explaining the immediate background to the Wells-Wachovia merger, the banks revealed: "Liquidity [at Wachovia] continued to decline and by the end of September 26, Wachovia's management was concerned that, without accessing the Federal Reserve's discount borrowing window, Wachovia's banking subsidiaries would not be able to fund normal banking activities on Monday, September 29." In theory, a bank experiencing short-term liquidity problems would borrow at the Fed's discount window and not opt for a merger at a distressed stock price. As a result, the regulators that oversaw the Wells-Wachovia deal should explain why that more orthodox route wasn't taken. Maybe they felt any indication that Wachovia needed substantial liquidity support would deepen the bank's problems and add to systemwide jitters. But if that is the case, it means the old tools didn't work and reforms have to come fast to address the liquidity problem. Granted, regulators are drafting proposals that require banks to do a better job managing liquidity. But investors likely wouldn't be able to monitor those from the outside. While regulators track liquidity as part of internal ratings procedures, that data isn't made public. Perhaps the solution is to build protection against liquidity problems into capital. Paul Miller, analyst at FBR Capital Markets, suggests that banks hold extra capital to reflect the proportion of their funding sources that have a high propensity to dry up at short notice. That has the advantage of making it economically attractive for banks to beef up their more stable funding. Building a new gold standard in capital regulations should be one silver lining of the credit crunch.