When banks use capital made of sand

November 12, 2009

Citigroup’s capital position appeared much improved when the bank reported third-quarter earnings, but a look beneath the surface shows that much of its capital is of questionable value.

According to its recent 10-Q, Citi had $38 billion of deferred tax assets as of Sept. 30, more than a third of the bank’s tangible common equity of $107 billion.

Backing that out, Citi’s TCE ratio — the inverse of leverage — is reduced from 5.7 percent to 3.7 percent. And when Citi adopts new accounting rules for off-balance-sheet assets, the ratio will be reduced further to 2.8 percent.

Bank regulators should be concerned. To fortify their balance sheets so they can withstand systemic events without government support, banks need genuine capital available to absorb losses.

Deferred tax assets, or DTAs, don’t fit that bill. Imagine an individual in bankruptcy court asking to pay off his credit card debt with tax-loss carryforwards.

So long as Citi generates profit, its DTAs have value. But earnings could evaporate quickly if the Fed decides it has to prick the new asset price bubble being inflated by near-zero rates, or if an unanticipated systemic event puts stress on Citi’s balance sheet.

There may be another problem with Citi’s ability to realize the value of its DTAs. According to Barclays analyst Jason Goldberg, future transactions in the company’s stock could be considered an “ownership change” that would require some DTAs to be written off. That would be a direct hit to tangible common equity.

Citi’s pile of DTAs may be the largest, both absolutely and as a percentage of TCE, but JPMorgan Chase, Bank of America and Wells Fargo each have their own.

Some regulators are taking action. As Robert Barba reported in the American Banker, the California Department of Financial Institutions last week took the unusual step of instructing Hanmi Financial Corp. to raise common equity as part of an enforcement action.

It’s a promising portent. Bank regulators have a lot of power to force Citi and the other big banks to raise real capital. They should use it while markets are receptive.

11 comments

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I have to admit I don’t understand why dta’s are allowable as capital.

Posted by Andrew | Report as abusive

Well a portion is typically disallowed from regulatory measures like Tier 1. But of course there’s other capital included there that isn’t common and so isn’t in the all-important first loss position…

Posted by Rolfe Winkler | Report as abusive

Wonderful sleuthing!

Posted by Dan Hess | Report as abusive

Hopefully the hour glass is not tipping and this is not made of sand castles. There must be adequate and matched future profits to utilize this asset, the credit entry should be a non distributable reserve rather than tiered capital. Issuing preferential shares should be quite attractive at this stage. The sands of time will prove this.

Posted by Casper | Report as abusive

Do I understand correctly that deferred tax assets lose their value when a company has not returned to profit after a certain number of years? Do I recall correctly that GM lost a large amount af DTA this way a few years ago? How many years is this period in the US?

Posted by Martin, the Netherlands | Report as abusive

I’m not a sophisticated numbers cruncher, but it seems to me that “off balance sheet” transactions should be governed by one simple rule… they should not exist.XEL, Enron, and others used them as a devil’s workshop.Investors and regulators need transparency.

Posted by Charles Johnson | Report as abusive

Most interesting opinion, for one reason or another it reminded me of ‘Jerome Daly’ case.

Posted by Tom | Report as abusive

[...] Concerns over US banks Capital Reserves (Citibank) [...]

Some day individuals will be able to use “capital loss” carry forwards, not useable in the year incurred, like a corporation. If I were a U.S. Senator, I would push for a bill from Congress allowing INDIVIDUALS with capital losses, from the sale of securities (traded on public exchanges)to sell them to persons who have capital gains that want to reduce their federal tax burden. Both the persons with the capital loss would get an immediate financial benefit and the person buying the loss would reduce his tax burden, something only a corp. can do now.

Posted by Thomas Shafovaloff | Report as abusive

Sand indeed, and it’s thrown in the eyes of the public.

Posted by yr | Report as abusive

[...] Banks Use Capital Made of Sand (Reuters) Banks need genuine capital available to absorb losses, not giant lumps of deferred tax assets, [...]

Martin, IFRS or US GAAP should dictate. Some entities stick this on their balance sheets as an asset, in my opinion, when it becomes clear that there will be no future profits, it should be removed somehow, or bought over, but that requires care to avoid tax evasion.

Posted by Casper | Report as abusive

Rolfe, I have had a bad American weekend. The tides tend to wash sand away. The US President seems to have announced a dramatic revival in US manufacturing and exports. Presumably that excludes GM foods and IT and Armament and Surfboards. Do you know what will be really nice:- if he would visit the Southern Hemisphere countries for a cup of tea with no strings attached. Even better, if he does a road show in his own country and see the distress that has been caused. The World is tired of the US rhetoric, and quite frankly, the US is destabilizing the World financial systems by trying to baby sit everyone.

Posted by Casper | Report as abusive

[...] Rolfe Winkler » Blog Archive » When banks use capital made of sand … [...]

[...] is actually an issue that’s been talked about for a while. Mike Mayo and Rolfe Winkler have been banging the drum on this, warning that the eorsion of these tax credits would eat into [...]