When banks use capital made of sand

Nov 12, 2009 19:04 UTC

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.


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

Cushions are thicker but don’t get comfy

Oct 30, 2009 17:46 UTC

In a spot of good news for the economy, banks continued to rebuild their capital cushions in the third quarter. But are they doing so fast enough? One risk going forward may be the size of their securities portfolios, which could expose them to significant interest rate risk when the Federal Reserve finally taps on the brakes.

(Click table to enlarge in new window)


Measured by tangible common equity, the biggest banks are levered 20 to 1, a solid improvement from last quarter’s 24 to 1 and a giant leap from 30 to 1 in the third quarter a year ago. (These figures exclude off-balance sheet assets, which will increase leverage when they are consolidated beginning next year).

Tangible common equity is the crucial measure of bank capital because it is the primary cushion banks have to absorb losses. When it gets too low, creditors panic and bank runs ensue. From a systemic risk perspective, it’s great that banks are rebuilding this cushion.

The crucial question is how they’ll fare in a less favorable monetary environment. While consumer prices show little sign of inflating, asset prices are another story. Interest rates near zero have encouraged investors to chase risky assets. If that trend continues, the Fed may have to unwind its balance sheet and raise rates sooner than it would like, putting banks in a tough position.

FBR Capital Markets points out in a recent note to clients that many banks have poured excess liquidity into their securities portfolios, “which could present significant interest rate risk” when the Fed reverses course.

Compared with last year, the top 10 commercial banks have increased the size of their securities portfolios nearly 40 percent, with JPMorgan Chase’s rising over 150 percent.

And while securities prices are more immediately sensitive to monetary policy, loan portfolios would be impacted as well. Early next year, after the Fed turns off its printing press and after the home-buyer tax credit expires, real estate prices could resume falling. This will put more owners upside down on their loans, keeping default rates high.

Banks are extending loans, pretending that asset prices will recover past peaks, an unlikely prospect if the Fed does its job.

Now it’s up to regulators to deliver higher capital requirements so that banks can withstand the end of government support. After all, 20 to 1 leverage is still very high. It only looks prudent against the insane levels reached last year.


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Ending the off-balance sheet charade

Sep 17, 2009 15:43 UTC

Investors have more than one reason to celebrate two new accounting rules. Besides forcing banks to fess up to the risks they are carrying on their books, new standards for off-balance sheet assets will make it harder for companies to inflate earnings artificially.

The new rules – FAS 166 and 167 – are desperately needed to prevent banks from hiding assets to increase leverage. Lending that isn’t supported by capital is a main ingredient behind unsustainable credit bubbles, and banks’ off-balance sheet games played a big role in the most recent one.

But another reason banks like off-balance sheet structures is that it enables them to manufacture profits.

Coming up to the end of a quarter, if a company is a bit short of its earnings target, it can package some assets together into a security and “sell” them to an off-balance sheet entity.

The entity is conjured out of thin air with a small equity investment by the company itself. The entity “buys” the securitized assets at a nice markup, enabling the company to book a profit on the sale.

Is it really a sale if the company still owns the risk? Of course not. If I sell an asset to you, a share of stock for instance, then I transfer all the rights of ownership. Any gains or losses in the stock are yours alone.

With many off-balance sheet entities, however, companies aren’t really transferring risk to anyone else. They’re just pretending to do so in order to lever up and recognize a gain.

It’s the acknowledgment of risks that is most important. Pushing assets off balance sheet — into the “shadow banking system” — put them beyond the reach of regulators, whose job it is to make sure banks have enough capital to absorb losses.

For their part, banks like to fly as close to the sun as possible, operating with as thin a capital cushion as regulators will allow. This is the essence of leverage. The more assets a firm controls relative to the equity on its balance sheet, the higher its potential returns on equity.

If you put down 20 percent to buy a house, and the house’s value appreciates 10 percent, then the return on your equity is a tidy 50 percent. But if you put down 5 percent, that same 10 percent increase in price is a 200 percent return.

The trouble with this strategy is that it works in only one direction. If asset prices fall, banks with smaller equity cushions go horizontal rather quickly.

At the height of the bubble, big banks were operating with equity cushions in the range of 2 to 3 percent. And that was before accounting for off-balance sheet assets.

Since then, banks have raised more capital, putting them in the range of 4 to 5 percent, but bringing assets back on balance sheet will have a meaningful impact. Citigroup will be adding $159 billion of assets, Bank of America $150 billion, JP Morgan Chase $130 billion and Wells Fargo $109 billion.


Goldman Sachs and Morgan Stanley haven’t yet disclosed how much they will be bringing back on, according to their most recent quarterly filings with the SEC.

Unfortunately, and contrary to recent comments about the importance of raising capital from President Barack Obama and Treasury Secretary Timothy Geithner, regulators are considering giving banks a year to phase in these assets for regulatory capital purposes.

This seems foolish. With equity markets nice and bubbly again, it’s not very difficult for banks to sell stock. If regulators make clear that additional capital will be required soon, banks may actpre-emptively to raise it now.

The system will certainly be stronger if they do.


it said banks or gloden–s were in so..lvency, suddenly, all banks started making money, is there anything wrong, I am really happy someone else knows more than I do..

Posted by jerry | Report as abusive

Banks still need bigger cushions (Q2 TCE update)

Jul 28, 2009 15:57 UTC

reuters-logoIt was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Yes, leverage is down, but only relative to the obscene levels reached a year ago.  Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.


(Click table to enlarge in new window)

Tangible common equity remains the crucial measure of bank capital because it’s the primary cushion to absorb losses. When that cushion gets low, creditors panic. Bank runs ensue and the financial system ceases to function.



Rolfe is right. Citi has already moved to shore up their TCE. Their public share exchange last week yielded over 60B bringing TCE to 100B and their current ration to 5.5% (over 9% tier 1 common). Will other banks follow suit? Will they be able?

Posted by Jim | Report as abusive