When Matt wrote his post the other day about starting a bank it got me thinking about the effect of what he is saying relative to profitability when we introduce a policy to be safe and carry capital reserves of 2 – 3 times more than todays banks.

Assumptions:

– demand deposits = demand loans

– GIC (CD) = Mortgages

– incremental investment in higher returning mortgages is funded from cash

Relevance to Bankwatch:

• A $4 increase in gross profit results in a 15% higher Return on Equity when a lower capital ratio of 10% is accepted.  Note the stock market values ROE over absolute profits.
• the increase in gross profit is not so much in absolute dollars, especially when we consider the additional risk taken on
• the relative risk of Regular Bank is exponentially higher with $200 more in loans and $200 less in equity – thats a $400 differential
• a 12% ($84) loan write down in Safe Bank is absorbed within the $300 capital, leaving them still at a substantial 24% capital ratio versus original 30%.
• a 12% ($100) write down in Regular Bank eliminates their capital and requires FDIC takeover – THEY ARE GONE!

The basic question then is whether the Regular Bank can make up the absolute dollar shortfall relative to Regular Bank of $4 (20% of Regular Bank gross) by efficient operations, less /no branches etc.

A 20% improvement seems doeable.

This simplistic model is deliberately just that – simple.  It does suggest though that there is an opportunity to consider a different model that will still satisfy shareholders, but also satisfy common sense and a more conservative risk profile.  Which Bank will step up to this model?

Thoughts and critiques from the Basel experts welcome.  Note I ignored cost of capital for this exercise.

Alos here is the spreadsheet.  safe bank Note:  download, save, and change name to safe bank.xls – then you can open in Excel or OpenOffice.