What it means
Banks run on very high borrowing, so a small fall in the value of their assets can put their capital at risk. Analysts therefore look for a simple measure of how much real owner capital stands behind those assets.
The tangible common equity ratio does that by stripping out items that would not help in a crisis. The top of the ratio is tangible common equity, which is shareholders' equity less preferred shares and less goodwill and other intangible assets.
The bottom is tangible assets, which is total assets less the same goodwill and intangibles. Both sides exclude intangibles so that the comparison is consistent.
A typical healthy bank may show a ratio somewhere in the mid single digits to low double digits, though there is no universal target. A low ratio means the bank is heavily leveraged, so a modest loss on loans could eat into the cushion.
A high ratio means the bank has more room to absorb problems but may earn a lower return on equity. The ratio became widely quoted during periods of banking stress, when investors wanted a measure that was harder to flatter than the regulatory ratios.
It does not weight assets by risk, so a bank full of safe government bonds and a bank full of risky loans can show the same figure. Analysts therefore use it alongside risk-weighted measures.
For non-specialists, the ratio is a quick way to see how much of a bank's balance sheet is truly funded by shareholders. If the figure is 5%, then a fall of 5% in the value of tangible assets would remove the shareholders' stake entirely.
That framing makes the risk easy to explain in a meeting. The ratio also guides decisions about dividends and growth.
A bank that wants to lend more must fund the new assets, and if it cannot raise fresh equity it has to retain profits to keep the ratio steady. Paying out too much in dividends can therefore slow the bank's growth.
In practice
Real-world examples.
Example
An equity analyst compares two banks of similar size. One has a ratio of 8.5% and the other has a ratio of 4.5%, mostly because the second bank has made several acquisitions that created goodwill. She prefers the first bank as a safer holding, while noting that it may earn a lower return because it uses less borrowing.
Example
A bank's finance director sees the ratio drift down from 7.0% to 6.0% as lending grows faster than profits. She proposes a plan to retain more earnings and reduce the dividend. The board agrees to hold the ratio above a floor of 6.5%.
Example
A credit rating team reviews a bank's annual report and calculates the ratio after removing goodwill from a recent takeover. The figure is lower than the bank's own headline ratio. The team notes this in its report and uses the lower figure when comparing the bank with its peers.
Formula
Calculation
Tangible common equity ratio = tangible common equity / tangible assets x 100
Tangible common equity = shareholders' equity - preferred equity - goodwill and intangibles
Tangible assets = total assets - goodwill and intangibles
A bank has total assets of $10,300,000,000, shareholders' equity of $1,200,000,000, preferred equity of $200,000,000 and goodwill and intangibles of $300,000,000. Tangible common equity = 1,200,000,000 - 200,000,000 - 300,000,000 = $700,000,000. Tangible assets = 10,300,000,000 - 300,000,000 = $10,000,000,000. The ratio = 700,000,000 / 10,000,000,000 = 0.07, or 7.0%.Case study
Seen in the real world.
Harlow Savings Group is an illustrative, fictional bank with tangible assets of $8,000,000,000 and tangible common equity of $560,000,000, giving a ratio of 7.0%. During a downturn the bank expected to lose $200,000,000 on its loan book.
After the loss, tangible common equity fell to $360,000,000 and tangible assets fell to $7,800,000,000. The ratio dropped to 360,000,000 / 7,800,000,000 = 4.6%, well below the level investors had come to expect.
The illustrative bank raised $240,000,000 of new common shares, lifting the ratio to 600,000,000 / 8,040,000,000, or about 7.5%. The share issue diluted existing shareholders, but it restored confidence and kept the bank's funding costs from rising.
Watch out
Common mistakes.
- Comparing the ratio of two banks without checking how much goodwill and preferred equity each has.
- Treating the ratio as a measure of risk, when it ignores whether the assets are safe or risky.
- Using total assets instead of tangible assets in the denominator, which gives a different and less consistent result.
Questions
People also ask.
What is a good tangible common equity ratio?
There is no single answer, but many analysts look for a ratio in the mid single digits or higher and compare it with the bank's peers.
How does it differ from regulatory capital ratios?
Regulatory ratios weight assets by risk and include certain debt-like instruments, while this ratio is simple, unweighted and based on common equity.
Why was it popular during banking crises?
Because it is hard to manipulate and focuses on the shareholders' real cushion, which investors found more credible than complex regulatory measures.
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