Regulatory arbitrage of the day, Citigroup edition

By Felix Salmon
April 19, 2011
Tracy Alloway for calling it as it is, in a post headlined "Citi’s Basel-dodging, capital-avoiding, accounting switch".

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Well done to Tracy Alloway for calling it as it is, in a post headlined “Citi’s Basel-dodging, capital-avoiding, accounting switch”. At issue is a pool of $12.7 billion in assets, which is housed at Citi’s “bad bank”, Citi Holdings.

In 2008, Citi decided that these assets were not available for sale, and rather were going to be held to maturity. Presto — the bank no longer had to mark the assets to market, and could hold them on its books at par instead. And the difference between par value and market value went straight to Citi’s precious capital, helping it look stronger.

Now, in the wake of a massive bond rally. Citi has decided to switch the assets back. No longer are they held to maturity; instead, they’re available for sale. At a stroke, Citi has to recognize all the gains and losses in the portfolio immediately — that’s $1.7 billion in losses, and $946 million in gains. But the losses can be applied against profits elsewhere in the bank, to reduce the total tax burden. Which is nice, because we wouldn’t want too much money flowing from Citigroup to the taxpayers which bailed it out.

Of course, banks can’t just oscillate back and forth between classifying assets as being held-to-maturity or marked-to-market at whim, depending on how such a classification makes them look in their quarterly report. That defeats the whole point of classing assets as being held to maturity in the first place. If you say an asset is going to be held to maturity, it should be held to maturity, not held to the point at which it’s no longer held to maturity.

And so Citigroup had to explain to regulators what excellent reason it had for changing the classification. And you’re going to love the reason it came up with. The authors of the new Basel III capital adequacy rules, it turns out, managed to notice that assets being held at par and held to maturity are naturally riskier than assets which the bank can sell at any time and is marking to market on a daily basis. And so the capital requirements on held-to-maturity assets are higher than the capital requirements on assets which are marked to market.

So far so reasonable. But Citi’s brainwave was to cite the new Basel III requirements as the fundamental change which would give them an excuse to switch classifications now that the bond market is looking frothy again. Basically, Citi went along to its regulators, and said hey, the capital requirements on these held-to-maturity assets are rather onerous, would you mind if we reclassified them so that we don’t need to hold as much capital against them? And the regulators said by all means, go ahead!

Of course, the assets themselves haven’t changed at all — they’re the same assets, being held at the same bad bank. But now the bad bank has a lower capital requirement, since the assets have been reclassified.

All that remains is to wait until the bond market goes down again, and see what new reason the bright sparks at Citi will be able to come up with to explain that actually, they want to go back to classifying the assets as being held to maturity. It’s all very simple, really: when bond prices are low, assets are held to maturity, and can sit on your balance sheet at par. When bond prices are high, they’re available for sale, and your capital requirements go down. The bank wins either way, while the regulators look like schmucks. And if Citi’s doing this, you can be sure everybody else worked it out long ago.

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