A Look Inside the Bank Capital Conundrum

Includes: BAC, C, HAFC, JPM, WFC
by: Rolfe Winkler, CFA

Citigroup’s (NYSE:C) 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% to 3.7%. And when Citi adopts new accounting rules for off-balance-sheet assets, the ratio will be reduced further to 2.8%.

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 (NYSE:JPM), Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) 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 (NASDAQ:HAFC) 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 capital. They should use it while markets are receptive.