Strong capital base necessary for future growth
As we read in our series on banking capital—read here—a bank has to keep a certain amount of capital aside for unplanned circumstances. This is a regulatory requirement. If a bank needs to increase its loan book, it has to keep an even higher amount of capital aside.
A bank’s growth can be limited if it doesn’t have enough regulatory capital. If the bank doesn’t have enough capital, it will be forced to dilute its equity to raise capital. This will reduce the earnings per share (or EPS) and returns on equity. This will negatively impact valuations. We discussed this in our series on bank valuations—read here.
A bank that isn’t capitalized well will have discounted valuations in the long run. Also, a bank’s ability to withstand benign economic times when loan default rates rise isn’t strong. Wells Fargo (WFC) has a policy where it’s always well capitalized to leverage on future opportunities.
Wells Fargo is the best capitalized bank among its peers
As we can see in the above chart, Wells Fargo is the best capitalized bank. In fact, it’s the only large bank—apart from Bank of America (BAC)—that doesn’t have a capital shortfall to meet the regulatory leverage ratio requirement of 5%.
It’s a catch-22 situation for banks like JP Morgan and Citigroup. If they raise capital, their EPS and return on equity will likely fall. This will lower their valuation. In contrast, if they don’t raise capital, their future growth will likely be limited.
The valuations downgrade for Wells Fargo, on account of future capital requirements, isn’t likely. The bank’s safe and sound strategy will likely to pay off in the future.