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Were the folks at Zerohedge.com looking at the best numbers when they argued that Canadian banks were just as levered as troubled European banks?

In a simple analysis that generated a great deal of commentary, a blogger at Zerohedge.com, an oddball but widely followed financial site, suggested that Canadian banks were as leveraged as European banks because they have low ratios of tangible common equity to total assets.

But there's an argument that looking at that ratio is the wrong way to judge a bank's strength because it ignores the composition of the assets.

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A better number might be the ratio of tangible common equity to risk-weighted assets.

In times of stress, analysts have focused on tangible common equity as a baseline measure of strength. It is calculated as the amount of equity a bank has, after excluding preferred equity and intangibles (whose value might be questionable in a crisis). Set that tangible equity against a bank's assets, and you can see how much wiggle room a bank has if its assets start to go bad.

But what's the best measure of assets? Is it total assets, as the Zero Hedge analysis assumes, or is it risk-weighted assets?

An argument for total assets and against risk-weighted is that risk-weighted involves judgement calls on the riskiness of loans and investments. In many cases, the judgements are made by banks and overseen by regulators. Assets such as Treasury bonds are judged much less risky than a loan to a consumer, for example. Banks with low-risk assets can carry less equity.

There's no judgement in total assets. They are an absolute.

The argument the other way runs that by using total assets you are lumping in Canadian banks' assets like mortgages with the Greek bonds on the balance sheets of European banks. In other words, while you think you're getting an apples to apples comparison, you're not adjusting for the fact that some apples are fresh and tasty and some are rotten.

Interestingly, a 2009 study by McKinsey found that, when looking at the global banking crisis from 2007 to 2009, the ratio of tangible common equity to risk-weighted assets was the best predictor of bank distress.

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It doesn't appear that McKinsey looked at the debate over which TCE ratio to use. What the analysts did find is that as the TCE/RWA ratio rose above 7.5 per cent, the likelihood of banks getting into distress declined sharply. Below that level and banks started to get into trouble.

And in that case, Canadian banks, with average ratios over 10 per cent, look very strong.

Here's an excerpt from McKinsey's survey of the 2007-2009 period.

"Banks with a TCE to RWA ratio of less than 6.5% to 7.5% accounted for a disproportionate share and the vast majority of distressed banks. Approximately 21% of the largest global banks became distressed during the crisis. Banks with a TCE to RWA ratio of less than 6.5% prior to the depths of the crisis had a distress rate of 33% and made up 58% of distressed banks. Banks with a TCE to RWA ratio of 6.5% to 7.5% had a distress rate of 25% and, together with those with a lower ratio, made up 83% of all distressed banks."

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