INSIGHTS

On September 13, 2010

Over Collateralization Has Time to Adjust

---

The surprising conclusion of the Basel agreement is looking a lot like a sheep in wolf’s clothing. The defining of the recommended capital requirements to over twice the current levels was fairly expected in most circles as the general accepted level. From the beginning, all banks were expecting a larger increase in reserve requirements, common equity as well as higher Tier 1 ratios. Recall Tier 1 assets will include reserves, retained earnings and equity or capital stock. There are rankings that range from critically undercapitalized to well capitalized.

What allowed the financial sector to breathe a sigh of relief is the timeline in which banks need to comply with the more stringent levels of required capital. We will begin to see the new requirements implemented in 2013; however, we will see the bulk between 2016 - 2019. Thus, we believe the over collateralization that permeates the banks’ balance sheets currently will have time to adjust downward as the overall economy falls into a more predictable growth pattern over the next few years.

The general rules now look to be roughly 7% of their assets held in common equity. According to the Wall Street Journal, large banks in the United States have been held to 4% common equity levels with international standards at 2%.

We have continued to believe the historic amounts of cash built up in the system is both broad and deep and will ultimately work its way through the economy. Consider the following difference between current cash levels and what long term expected growth rates of cash at commercial banks would normally have been expected to be. Quite a lot of money that is earning very little return at current levels, that we believe will ultimately find a home where better returns reside.

Cash at Commercial Banks vs Long Term Growth Rate

Source: Federal Reserve, Bloomberg. See Charts/Graphs Disclosure.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.