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".

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

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.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see


What you and Tracy failed to notice is that Citi has subsequently sold 75% of these assets (at or above the mark used at the time they were transferred from HTM to AFS) and is likely to dispose of the rest soon (see slide 12 of the earnings deck). Not all actions by TBTF banks are sinister. Citi had to make the transfer from HTM to AFS before the assets could be sold. Simple as that. Dig no deeper for ulterior motives. Also, the risk weights don’t change based on classification. The assets already had high risk weightings, which was the motivation for Citi to sell them, not to reclassify them. If you want to heap criticism on Citi, it should be for the reclassification back in 2008, but this recent action was completely logical.

Posted by NoNamesLeft | Report as abusive

“But the losses can be applied against profits elsewhere in the bank, to reduce the total tax burden.”

An accounting change like this doesn’t reduce the firm’s tax burden.

Posted by Beer_numbers | Report as abusive

read both you and tracy. still do not know how citi convinced regulators that they could switch back.

Posted by david3 | Report as abusive


Doesn’t it exactly effect the firm’s tax burden? They are reclassifying an asset, recognizing a loss from the switch in principle, thereby changing the firm’s tax liability.

I am not a tax guy, though…

Posted by asimmo6 | Report as abusive

Regardless of Dodd-Frank or Basel III, financial institutions have never met a loophole or technicality that they don’t like and won’t exploit to the extent that their captured regulators will let them.

Posted by richardcm | Report as abusive

This is good, because I think it’s healthy for every generation to bail out its incarnation of Citibank. My grandparents did it, my parents did it, I did it. Now my children will be able to do it.

Posted by RZ0 | Report as abusive

Firms aren’t taxed on gains/losses until they are realized (i.e., the asset is sold). So it doesn’t matter how the *unrealized* gain or loss is calculated, the firm won’t owe taxes on the gain (or receive a tax benefit on the loss) until the asset is sold.

Posted by Beer_numbers | Report as abusive


I agree that, generally, there is no recognition of a gain or loss until the asset is sold. But I don’t think this hold true when an asset is in a bank’s trading book that is marked-to-market. The marked-to-market assets can generate gains and losses without being sold.

Having to recognize the past gains and losses on the “bad bank” assets upon moving them to the trading book is probably just a “catch up” feature so that mark-to-market gains/losses are recognized when assets are transferred into the trading book.

Posted by bklawyer | Report as abusive

Gains/losses on marked-to-market securities are recognized on the firms’ financial statements, as prepared under GAAP. So they will cause a firm’s reported Net Income to increase. However, taxes payable to the IRS are not determined by GAAP income, but by taxable income. And unrealized gains/losses do not affect taxable income.

Posted by Beer_numbers | Report as abusive


Yeah, but this isn’t just an unrealized gain/loss, they are changing their cost basis. Wouldn’t that changed there taxable income?

Posted by asimmo6 | Report as abusive

They are changing their basis for GAAP purposes. This doesn’t affect taxes paid. It’s similar to what happened when Berkshire Hathaway recorded an other-than-temporary impairment on its COP holdings about 2 years ago. They reported a loss on their Income Statement and a corresponding income tax benefit on the Income Statement, but that income tax benefit was simply a deferred tax item (stemming from GAAP accounting rules). It didn’t affect Berkshire’s tax payments at that time.

Same thing here – reclassifying and recognizing gains or losses may affect Net Income, but will not affect taxes actually paid.

Posted by Beer_numbers | Report as abusive

Isn’t Citi Holdings the place where Citi put the businesses it hopes to divest? I say “divest” because “sell” might make it sound like these assets have been available for sale all along.

Posted by Eric_H | Report as abusive

To elaborate, they are changing what the asset worth. So if it contributed $3 last year, and it contributes only $1 this year, doesn’t that result in tax savings?

Posted by asimmo6 | Report as abusive

Re: tax burdens — it’s true that the change in accounting principle does not change the taxes actually paid, but it does affect the tax expense reported for financial purposes, and the deferred tax assets or liabilities.

I think we need a concerted international effort to harmonize tax accounting and financial accounting. Companies should be allowed only one set of books for both purposes, so that there will be a useful tension between their desire to report lower earnings for tax purposes, and their desire to report higher earnings to make their stock look better. Hopefully by putting both of those forces into play on one set of books, they’d cancel each other out somewhat, and firms would quit playing so many games on BOTH sides.

Posted by Auros | Report as abusive

I see the error in my ways. No more accounting for me hah.

Posted by asimmo6 | Report as abusive

I see the error in my ways. No more accounting for me hah.

Posted by asimmo6 | Report as abusive

Beer_Numbers, I don’t think that is right for securities dealers. They must generally use the mark-to-market method for tax purposes, under which any mark-to-market gains or losses at the end of the year are treated as taxable income.

Posted by niveditas | Report as abusive

I’m not a tax guy, but my understanding is that your comment does not apply globally to all securities held by securities dealers, and does not apply to the specific Citi case at hand.

I’m basing my comment on reading Section 475 of the Tax Code here: _sec_26_00000475—-000-.html

which does say (as you note) that securities dealers have special taxation on marked-to-market securities. However, it says that it relates to only those securities held as inventory, and not for securities held for investment. I think that the securities that Felix wrote about are Citi’s securities held for investment, rather than as inventory. (I could be wrong here and I welcome correction. I’m not quite concerned enough to contact Citi’s IR department, but I’m guessing they could provide an answer.) If so, they would not gain any true tax benefit from the reclassification that Felix writes about.

However, I am confident that not *all* of Citi’s investments are taxed on a marked-to-market basis. If you look at the Income Tax footnote in Citi’s most recent 10-K, you’ll see a very large deferred tax position related to its investments:
A $16.8 billion deferred tax asset due to “Credit loss deduction”
and a $1.6 billion deferred tax asset related to “Investment and loan basis differences”.

I believe both of these items reflect losses that Citi has recorded on its Income Statement (along with a tax benefit for GAAP purposes), but for which they did not benefit on their tax return. They are deferred tax assets because Citi will realize those actual tax benefits (in the form of reduced payments to the IRS) when the underlying security is sold and the gain/loss is realized.

Posted by Beer_numbers | Report as abusive

Beer_Numbers, me neither, but I thought the point of this transfer is that the assets are no longer in the investment bucket, but in the trading inventory. In any case, as the first commenter pointed out, Citi is saying they have sold most of these assets, so the discussion may be moot :)

Posted by niveditas | Report as abusive