Citigroup Inc (NYSE:C) and Bank of America Corp (NYSE:BAC) have managed a neat trick since the beginning of the year, increasing their regulatory capital faster than retained earnings during 1H14. While this puts the banks in a good position for next year’s CCAR, which will use the banks’ balance sheets at the end of 3Q14, not all of their recent gains are repeatable and some of them could even evaporate as market conditions change.
“We estimate that regulatory capital grew at a 300% multiple of retained earnings at Citigroup Inc (NYSE:C) and 1000%+ at Bank of America Corp (NYSE:BAC) in 1H14. This was due to a myriad of factors that we divide into three parts: DTA consumption, the impact of rising dynamic caps on previously excluded Basel III capital and other ‘non-core’ factors such as OCI,” writes Bernstein Research senior analyst John E. McDonald
Citigroup benefits from DTA multiplier effect
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
Citigroup Inc (NYSE:C) was able to boost its regulatory capital by about $7 billion more than its $3.1 billion retained earnings in 1H14, mostly because of changes in deferred tax assets (DTA). First, Citigroup consumed $2 billion in DTA and had another $200 million in write-offs from changing state tax rates that effectively changed excluded DTA into allowable assets. But McDonald explains that there is also a multiplier effect here because DTA, MSR, and minority interests in financial interests are capped at 15% of Basel III tier 1 common capital. Increasing the total amount of allowable assets (such as by consuming DTA) means that the 15% cap covers more ground as well, giving Citi another $1.5 billion in regulatory capital basically for free.
The other $2.7 billion comes from a combination of changes in Citigroup Inc (NYSE:C) Other Comprehensive Income (OCI) such as unrealized gains on AFS Securities or foreign exchange that worked to Citigroup’s advantage this quarter, but could just as easily work against it in the future.
BAC regulatory capital gets a big boost from OCI
Bank of America Corp (NYSE:BAC) is in a very different position because most of its regulatory gains came from OCI, because it grew tier 1 common capital by $9.2 billion despite having no retained earnings and $3 billion from a combination of DTA being either consumer (~$1.5 billion) or reclassified (~$1.6 billion).
“BofA grew regulatory capital by a large $6b in 1H14 from factors other than earnings and DTA. Of this increase, we know $3.7b of the swing is attributable to unrealized gains in the AFS bond portfolio (OCI), but we have not been able to find an explanation for the remaining $2.3b increase,” explains McDonald, (emphasis his).
This still puts Bank of America Corp (NYSE:BAC) into a great position for the CCAR, but it means they might have more work to do before their regulatory capital is both high independent of market conditions.