Number of US banks with negative adjusted tangible common equity nearly doubles

The number of US banks with negative adjusted tangible common equity ratios reached its highest point since rising interest rates began to drag down the market value of banks' bond portfolios in early 2022.

Fifty-four US banks had negative adjusted tangible common equity (TCE) ratios at Sept. 30, up from just 28 in the linked quarter and 53 in the year-ago period. One of those banks was Sac City, Iowa-based Citizens Bank, which reported a negative 8.24% adjusted TCE ratio at Sept. 30 — the sixth-lowest among all US banks — around a month before its state regulator seized the bank and appointed the Federal Deposit Insurance Corp. as receiver.

TCE ratios — tangible common equity divided by tangible assets — have come under scrutiny over the past year as regulators' concerns about mounting unrealized losses grew. While TCE is not a regulatory ratio, agencies started to pay more attention to the metric because regulatory capital ratios for banks not designated as global systemically important do not include accumulated other comprehensive income and therefore do not capture the impact of underwater bond books.

"[Banks] are going to get more attention if it falls below 5%. They're going to get a lot more attention as it falls closer to zero or negative," Scott Coleman, a partner with Ballard Spahr LLP, said in an interview.

Citizens Bank's negative adjusted TCE ratio was one of multiple issues that led to its seizure. The bank's credit quality was also under pressure, reflected in its nonperforming loans to total loans ratio of nearly 10% in the third quarter, which created a "perfect storm," Coleman said.

"If a bank has a negative TCE ratio and their credit quality ratios are strong, there's going to be less concern with that institution than institutions that have both," said Jeffrey Voss, a founder and managing partner of Artisan Advisors, a consulting firm for community banks and credit unions.

A TCE issue in the red, combined with trucking loan quality issues that were the subject of an August consent order, caused regulators to take "quick action," said Donald Musso, president and CEO of FinPro Inc.

"Regulators are used to banks failing because of credit quality. That's usually a slow ride or a slower ride," said Jim Adkins, also a founder and managing partner of Artisan Advisors. "But over the last year or so, we've had these failures due to liquidity and it really shook them. ... So you throw on top of that some bad credit, that's just the final nail."

Negative TCE ratios

Credit quality was largely benign among other banks with negative adjusted TCE ratios in the third quarter. According to an analysis by S&P Global Market Intelligence, the top 20 banks with the lowest adjusted TCE ratios at Sept. 30 had a median nonperforming loan to total loan ratio of 0.42%. All but six had a nonperforming loan to total loan ratio below 1%.

Monterey County Bank, which had an adjusted TCE ratio of negative 4.05%, had the second-highest nonperforming loans to total loans ratio behind Citizens Bank at 5.81%.

However, regulators' assessments go beyond the combination of declining credit quality and TCE ratios.

"Any bank that has either a challenging earnings profile, challenging credit profile or a challenging funding profile, TCE is going to get looked at with much more scrutiny than would otherwise be the case," said Frank Sorrentino, a managing director at Stephens.

Community State Bank had the lowest adjusted TCE ratio in the quarter at negative 12.98%. Two other banks had double-digit negative ratios at Sept. 30.

Regulators' liquidity concerns grow

While banks with negative TCE ratios will find themselves under an intense regulatory microscope, increased regulatory attention begins when the ratio falls below 5%, advisers said.

In the third quarter, 502 banks had adjusted TCE ratios below 5%, the most since one year earlier when 610 banks were below that threshold.

With the March and May bank failures still fresh on regulators' minds and the increase in Treasury yields during the third quarter weighing on banks' accumulated other comprehensive income again, regulators are pushing banks to test their contingent liquidity more than ever before, advisers said.

Specifically, the agencies are asking banks to provide detailed information on how much liquidity they can access in time periods such as one hour or one day, FinPro's Musso said. They are suggesting banks should have enough contingent liquidity to cover all their uninsured deposits, "but I'm not sure that makes any sense, because it's not just uninsured deposits that can move in a digital liquidity event," Musso said.

Musso's firm is advising banks to ensure they can access at least 20% of their total deposit base in one day.

"All of a sudden on-balance sheet liquidity is not nearly as important as it used to be" compared to contingent liquidity, Musso said.