Bank Investing

CHAPTER 3Capital

“An essential message of the M & M Propositions as applied to banking, in sum is that you cannot hope to lever up a sow's ear into a silk purse. You may think you can during the good times; but you will give it all back and more when the bad times roll around.”

– Merton H. Miller, Journal of Banking and Finance, 1995

CAPITAL FOR A BANK

Capital serves as a cushion that allows a bank to absorb losses. The assets of a bank, namely the loans made and securities held, carry risk. Specifically, the loans may not be repaid, and the securities may fall in value. Regulators therefore require that a certain portion of these assets be supported by capital to protect depositors. Regulators, given the desire to protect depositors, are likely to want higher capital levels. Equity investors would be more desirous of an optimal capital level which is high enough to support growth and assuage regulators and yet be low enough to allow for an adequate return on capital.

The protection that capital affords comes in different forms. Apart from common equity, preferred stock and subordinated debt are also counted as different types of capital.

Likewise, there are many different capital and leverage ratios that bank investors can use in their capital adequacy analysis. We are partial to using what is known as the TCE Ratio (Tangible Common Equity/Tangible Assets) as it is conservative, intuitive, and easily comparable between institutions. There is no obligation for repayment ...