PACW - PacWest Bancorp: A Regulatory Capital Perspective

2023-05-05 11:44:47 ET

Summary

• PacWest faces intense media attention that may well lead to a self-fulfilling cycle.
• However, unlike recently infamous peers, PacWest's capital position is comparatively strong.
• In building on our previous article, we present adjusted regulatory capital ratio calculations to illustrate our view that PacWest is materially different.

We provided our perspective in an earlier article on PacWest Bancorp's ( PACW ) ability to absorb withdrawals of uninsured deposits through cash on hand and sales of liquid investment securities while maintaining the bank's regulatory capital ratios at levels acceptable from a regulatory standpoint after adjusting for the impact of realized losses within the investment portfolio. In this article we expand on that view and consider the company's regulatory capital position as compared to those of First Republic Bank (FRCB) and Silicon Valley Financial to illustrate our view that the challenges facing PacWest are not insurmountable despite ongoing speculation and turmoil.

Regulatory Capital

Regulatory capital ratios are, of course, the basic measure by which the strength of banking institutions are judged by regulators. The recent turmoil has been amplified by a quirk in the regulatory capital rules which allows, for the time being, banks to ignore the impact of unrealized losses on investment securities in their regulatory capital calculations. The result is a smoothing of regulatory capital ratios over time but also, in conditions of quickly rising benchmark interest rates, a potentially significant overestimation of a bank's fundamental strength.

In assessing banks we therefore calculate adjusted regulatory capital ratios which take into account a bank's ability to weather potential stress. We adjust these values by including unrealized losses on investment securities which are reasonably estimable and would be the first and easiest source of liquidity beyond cash and equivalents to cover unusual withdrawals. The sale of those investment securities, however, would convert previously ignored unrealized losses into realized losses, reducing equity in the regulatory capital calculation, and impacting the regulatory capital position of the bank.

First, let's consider Silicon Valley Financial which we'd previously noted was a textbook case of being in a position where the bank was insolvent regardless of its efforts to meet withdrawals. Notably, as of the company's last annual report, Silicon Valley Financial reported quite high regulatory capital ratios which made the bank appear quite well capitalized on the surface. However, recalculating the institution's capital ratios easily demonstrated that in a stress condition the institution was anything but:

Indeed, under a stress condition requiring the sale of investment securities to meet withdrawals Silicon Valley Bank was significantly undercapitalized - below even the threshold for undercapitalized - falling below every regulatory capital threshold and clearly insolvent. The reason was that the reported regulatory capital ratios ignored more than $13 billion (after tax) in unrealized losses on investment securities - neatly as much if not more than the bank's total reported shareholder's equity.

In contrast, First Republic's condition was slightly better - but only by a slight margin.

First Republic's adjusted capital ratios - after including more than $4 billion (after tax) in unrealized losses on investment securities, fell below certain well capitalized thresholds as well as all the Basel III thresholds after including the required capital conservation buffer. In this case the situation looks difficult but not necessarily catastrophic until noting that First Republic actually held relatively few investment securities as a proportion of assets unlike Silicon Valley Bank. First Republic, therefore, also needed to liquidate comparatively illiquid loans - also at a loss - in order to meet withdrawals in a stress situation which would have further eroded the regulatory capital ratios. First Republic thus faced both a liquidity issue and a regulatory capital issue.

PacWest, in comparison, is in a quite good position. The sale of all the company's investment securities - which would largely cover withdrawal of nearly all of the company's recently reported uninsured deposits - and realization of all currently unrealized losses would impact the company's regulatory capital ratios. However, unlike Silicon Valley and First Republic, the bank would remain a well-capitalized institution. Indeed, the only metric we estimate PacWest would potentially fall below would be the CET1 ratio including the capital conservation buffer and even then just barely - by 0.1%.

Conclusion

PacWest is the subject of significant speculation that, as before, may well become a self-fulfilling cycle despite the institution's ability to withstand significant additional deposit withdrawals without impairing its capital position as was the case with its more infamous peer institutions. It's possible we could be proven incorrect in our perspective - possible even, though we consider it doubtful, within the next day. However, at this point, there is little reason to believe that the bank's core capital position has changed significantly in the last several days. PacWest may still falter in the face of significant public fear and media speculation but not because the bank's core financial position was fundamentally weak.

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