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Regulatory focus on unrealized losses makes liquidity planning key for banks

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Regulatory focus on unrealized losses makes liquidity planning key for banks

U.S. banks need to start preparing for stricter regulatory oversight of capital and liquidity, as agencies grow increasingly worried about unrealized losses in banks' securities portfolios.

In a rare move, regulators have begun publicly expressing concern about banks' underwater bond books and the potential that banks would have to sell securities and recognize what are currently unrealized losses. In interviews with S&P Global Market Intelligence, bank lawyers and advisers said the agencies are keeping a sharp eye on ratios such as tangible common equity and loans to deposits. Banks can prepare now for increased regulatory oversight and tougher exams by lining up other funding sources, preparing thorough liquidity plans and stress-testing those plans, the advisers said.

If regulators believe a bank may run into a liquidity crunch, they could limit dividend payments, the rate the bank can pay on deposits and the ability to access Federal Home Loan Bank borrowings, among other actions.

"The regulators have a valid concern, and they're out there expressing it," said Jeffrey Voss, founder and managing partner of Artisan Advisors, a consulting firm for community banks and credit unions. "They're giving fair warning to banks: 'Be prepared when we come in, we're going to be looking at this. And if you're not prepared, what we can do to you will actually just exacerbate the problem.'"

Tangible common equity ratio grows in importance

One ratio regulators are paying close attention to is tangible common equity, or TCE, which is tangible common equity divided by tangible assets. While TCE is not a regulatory ratio, regulators are starting to pay more attention to it since accumulated other comprehensive income, or AOCI, is not included in regulatory capital ratios, for any banks except global systemically important banks, therefore they do not capture the impact of underwater bond books, advisers said.

The majority of bonds that most banks hold are in available-for-sale, or AFS, portfolios, which must be marked to market on a quarterly basis. Changes in the values of the AFS portfolios are captured in AOCI. Higher interest rates have weighed on the value of bonds that banks own since they now carry below market rates. As a result, the vast majority of U.S. banks have recorded a surge in AOCI losses.

"Regulators have been clear that tangible equity is a loss-absorbing capital," said Matt Resch, managing director and co-head of M&A and capital markets with PNC Financial Institutions Advisory Group. "If the credit cycle turns and there's now an uptick in credit losses, it's tangible equity that can absorb those losses. For banks that have seen a pretty significant impact to the tangible capital ratios, if now we end up having a turn of the credit cycle, it's only going to exacerbate that problem."

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An increasing number of banks have posted TCE ratios below 5% for the past three quarters, an analysis by S&P Global Market Intelligence found. In the third quarter of 2022, 430 banks had a TCE ratio between 2% and 5%, up from 287 in the second quarter of 2022 and just six in the third quarter of 2021.

With deposits abating and the potential for a recession that could mar credit quality, regulators are starting to take a closer look at banks with TCE ratios around 5%, according to Donald Musso, president and CEO of FinPro Inc.

"Everybody that's falling below certain metrics are getting calls and visits," he said.

When a bank approaches 2%, 0% or negative TCE, "that's when the real problem starts to occur," Musso said, adding that regulators could start putting restrictions on banks through consent orders.

As of Sept. 30, 2022, 68 banks had a TCE ratio between 0% and 2%, compared to 42 in the second quarter of 2022 and just one in the third quarter of 2021. Further, 31 banks had negative TCE ratios in the third quarter of 2022, up from 11 in the linked quarter and none in all three quarters prior to that.

Along with regulators, investors are also balking at falling TCE ratios.

"It's not just the regulatory risk. I mean when you get down to 2% tangible equity, you've got a real value risk, if you will. Investors are going to look at you and say, 'What the heck?,'" Musso said.

However, despite the deterioration of some banks' TCE ratios, the industry is still in good shape, with a median TCE ratio of 8.3% at Sept. 30, 2022.

Other factors under consideration

But regulators are not solely focused on TCE when reviewing banks' liquidity positions, sources said. Instead, they are interested in a bank's total depreciation of all assets, including both AFS and held to maturity, or HTM, according to Bart Smith, partner, managing director and head of risk and regulatory support at Performance Trust Capital Partners.

Banks with good TCE ratios but outsized depreciation in areas other than their AFS book could still fetch regulatory scrutiny, he said.

"The issue is liquidity from a regulatory perspective and how depreciation diminishes your ability to meet potential outflows," Smith said.

Regulators are taking banks' deposit bases into account, according to Scott Coleman, a partner with Ballard Spahr LLP. For example, regulators may be more concerned about a bank with a higher concentration of brokered deposits versus one with a stable core deposit base, he said. They are also paying attention to loan-to-deposit ratios in their reviews as well, some sources said.

"I think it really matters if you got an elevated loan-to-deposit ratio and you're already thin on capital," said Frank Sorrentino, a managing director in Stephens financial institutions group.

On a recent episode of the "Street Talk" podcast, Hovde analyst Brett Rabatin said the Federal Reserve may want to have a conversation with banks that have a loan-to-deposit ratio close to 100% and less than 6% TCE.

Consequences will 'exacerbate' a liquidity crunch

If regulators were to have concerns about a bank's liquidity position, they would likely start with informal actions, rather than opting for formal, public orders that could cause more harm than good, Artisan Advisors' Voss said.

"Those formal actions have consequences — and I think that's where the regulators want to be very careful this time around and not push banks into more problems than they actually have to have," he said.

Instead, regulators will likely address this matter informally through exams and conversations, Voss said. Musso has seen banks receiving Matters Requiring Attention regarding this issue.

Advisers urged banks to prepare now to avoid any regulatory actions because most of the actions the agencies will take will dig banks into a deeper hole by limiting or removing funding levers.

One action regulators could take is limiting the interest rate a bank can pay on deposits or limiting the bank's capacity to bring in brokered deposits.

"If those restrictions are applied to a bank who's not well capitalized, that makes it even harder to retain the liquidity that they need," said Kathy Marinangel, a director at Artisan Advisors. "When that occurs, that exacerbates the problem."

Another implication is the inability to borrow from FHLBs once a bank's TCE ratio hits 0%. In that case, a bank must get approval from regulators. That would take away another funding lever for banks, as regulators would likely be "reticent" to approve a waiver for FHLB borrowing from a bank with a 0% or negative TCE ratio, Smith said.

Regulators' concerns could also be reflected in a bank's CAMELS rating, which measures a bank's capital adequacy, asset quality, management, earnings, liquidity and sensitivity on a scale of one to five, with five being the worst. Musso has already seen some banks' liquidity and management ratings bumped up.

"We're definitely going to see the problem-bank count going up," he said. "You're going to really see it move in the first quarter."

A particular headache for S-corp banks

In the event of a liquidity crunch, regulators can limit banks' ability to pay dividends, which could be a particular issue for S-corporation banks. In an S-corp structure, shareholders are liable for the company's federal income taxes, and typically S-corp banks cover shareholders' tax liability through dividends.

Currently, 17 of the 31 banks with negative TCE ratios at Sept. 30 are S-corps, according to S&P Global Market Intelligence data.

The Small Bank Holding Company Policy Statement says banks should refrain from paying dividends if their debt-to-equity ratio is greater than 1-to-1. If the bank's debt-to-equity ratio is greater than that, the bank would have to consult with regulators about paying dividends, Coleman said.

But, "even if they get approval for a distribution in the first quarter here, as that debt-to-equity ratio is still impacted by [AOCI] in 2023, they might have to continue to make requests each calendar quarter in 2023," he said.

Given that dynamic, Coleman is having conversations with some S-corp banks about converting to C-corps. If a bank were to convert, it cannot revert back to an S-corp for five years.

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Preparing for additional regulatory oversight

To protect themselves against declining TCE and subsequent regulatory scrutiny, banks can bolster liquidity by utilizing FHLB borrowings, deposit listing services and brokered deposits, Musso said.

Banks should create detailed liquidity plans and stress-test those plans, sources said. The plan should identify sources of liquidity the bank could access quickly if needed.

Another major focus of that planning should be the bank's deposit base, Smith said.

"You need to have some kind of stress plan for deposits and the roll-off of deposits," he advised. "What are your expectations normally? What are your expectations stressed? And then what kind of on-hand assets do you have available to cover that potential outflow?"

If a bank does not have a "stock of liquid assets" to meet any potential deposit runoff, or if it plans to meet any runoff with depreciated securities sales, that would be a "critical issue" to regulators, Smith said.

"Banks that don't have any projection, don't have any kind of appreciation for the need to have some asset-based liquidity support, those are the ones that will be criticized," he said. While substantial deposit runoff is not likely, it is possible in this environment, particularly as deposit competition heats up, Smith added.

Unique situations that impact deposits can unfold as well. Silvergate Capital Corp. recently experienced $8.1 billion in deposit runoff in the fourth quarter of 2022 following the fallout of FTX's downfall and of cryptocurrency more broadly. The bank accessed $4.3 billion in FHLB borrowings and sold $5.2 billion in securities at a loss of $718 million as a result. The Street sent the company's stock falling nearly 43% on the day of the announcement.

Exams getting more stringent

Banks' liquidity plans and stress tests will be important during upcoming exams, experts said, as regulators take a harder look at capital and liquidity due to their worry that potential economic tumult could force some banks to sell securities at a loss.

"In 2023 examinations, there's no question liquidity is going to get a lot of attention," Coleman said. "If I were preparing for an examination in the first quarter of 2023, I'd be looking at my liquidity policy, determining whether it needs be strengthened or not and how it needed to be strengthened."

Exams have become "much tougher" in the past few months, Musso said, because "nobody wants to have a liquidity crisis on their watch."

"They're doing everything they can right now to dot I's and cross T's so that any bank problems are not on their watch," he continued. "As bankers, we should plan for that, and we should preempt it by having those things ready for the regulators when they ask for it."

M&A review will feel the impact too

Similar to exams, capital and liquidity will take a larger role in M&A review, experts said. While regulators' scrutiny of bank M&A deals has intensified in the past few years, they will begin taking an even harder look at capital and liquidity.

To prepare, buyers should be thorough in laying out liquidity plans, stress-testing those plans, and showing proforma capital and liquidity ratios, according to advisers.

In some cases, regulators may be hesitant to approve transactions that have a negative impact on the buyer's regulatory capital ratios, according to a transcript of a recent speech by Rodgin Cohen, senior chairman with Sullivan & Cromwell LLP, at Wells Fargo's Bank Bootcamp. In a deal, the buyer must mark the target's assets to market at close, which can reduce regulatory capital ratios and accounting value, Cohen said.

"I suspect that the regulators will be highly reluctant to approve a transaction that takes a bank below or even just to well-capitalized status," he said. "What is less clear is how close will the regulators permit a purchasing bank to get to the well-capitalized level if the decline is largely due to a purchase accounting adjustment."