Identifying and Managing Tangible Capital

Coming out of the Great Recession, banks had a revised international framework for assessing bank capital and liquidity. The new framework introduced Common Equity Tier 1 (CET1) as a fourth capital ratio. By excluding goodwill and many intangible assets from its definition of capital, CET1 largely replaced tangible capital as a reference point for a number of parties. Additionally, the new framework allowed all but the largest institutions to make a one-time opt-out decision to exclude Accumulated Other Comprehensive Income (AOCI) from capital ratios.

The Federal Housing Finance Agency (FHFA), which is FHLBank Boston’s regulator, did not change its framework to align with these other industry changes, however. As a result, FHLBank Boston’s primary assessment of capital adequacy remains tangible equity-to-assets (tangible ratio), which is inclusive of AOCI. AOCI is itself predominantly a function of unrealized gains and losses on Available-for-Sale (AFS) investment securities.

Because of the rapid increase in interest rates this year, essentially all institutions with AFS securities have seen significant losses and, as a result, tangible ratios have declined. The larger the AFS portfolio and the longer the duration, the more significant the decline.

Bank and credit union members of FHLBank Boston are assigned a credit status category based on an overall assessment of financial condition that determines the level of documentation required for pledging loan collateral and the lendable value of those assets.

• Category 1 depositories may opt to file Qualified Collateral Reports (QCRs) that allow the member to pledge only totals on owner-occupied, one- to four-family residential mortgages;
• Category 2 depositories must list all loans in a format approved by FHLBank Boston; and
• Category 3 depositories must list and deliver all loans to FHLBank Boston.

Additionally, Category 3 members need to apply to take any new advance with a term of one year or more through a Supplement A form.

Hard limits on specific tangible ratios no longer necessarily determine a member's credit status category. Any member with a negative tangible ratio, however, is ineligible to take new borrowings unless the member’s primary regulator submits a waiver on its behalf. Members with a negative tangible equity ratio but sufficient collateral may renew maturing advances for a term of no more than 30 days.

Depositories should understand where their tangible ratios stand and then estimate the impact to their tangible ratio based on a given move in interest rates. 

Since they are not subject to income taxes, credit unions see faster changes to their tangible ratios than banks because AOCI is not moderated by a tax shield.

Generally sheer size of the AFS investment book as a percentage of assets is the single greatest element of downside risk to tangible capital. As of third quarter of 2022, that metric at member banks and credit unions with total assets below $100 billion was 15.9% and 9.8%, respectively. A minority of members has levels greatly exceeding these averages, however. About 17% of that same cohort of member banks and 10% of member credit unions have AFS books that exceed 25% of assets.

While all should understand the dynamics of the concern, most institutions have minimal risk from this issue because their AFS book as a percentage of assets is smaller than their surplus tangible capital.

For those that need to more closely monitor their exposure, however, a comparison of the horserace of organic earnings power to potential yield curve risk and the passage of time would be beneficial. All else equal, time reduces duration and portfolio principal, resulting in lower risk.

FHLBank Boston crafted a tool that members can use that estimates what move in interest rates would have to occur before an institution breaches the credit status category thresholds. Most will find that only very extreme interest-rate moves put them at risk. 

Below are three tables that provide an example of a hypothetical $1 billion bank member that presently has a tangible ratio slightly above 7%.

In the hypothetical example above, rates would have to move up 5.88% before hitting a tangible ratio of 3.5% and an increase of 11.36% in bond yields in a single quarter before their tangible ratio would go become negative.

The dollar threshold calculations include the value of earnings over the time horizon indicated (based on the ROE user input), and the yield curve change thresholds contemplate both the effect of the tax shield on AOCI plus the organic reduction in duration over the time horizon indicated.

If a judicious course of inaction isn’t a viable path, institutions could assess alternative strategies depending upon their position and risk tolerances.

This strategy could partially or fully neutralize the issue depending upon the notional and terms selected without needing to recognize loss on the income statement. Depending upon trading terms, the trade-off is the potential introduction of counterparty risk and operational risks, especially with collateral management. For members comfortable with derivatives, this can be an effective option.

This tactic most directly and immediately sterilizes the issue at the cost of recognizing losses through the income statement. Members should consult their accountants or auditors, but re-classifying securities memorializes a loss at what could prove to be an unfavorable moment and could limit their ability to make future changes to their investments.

Deleveraging the balance sheet must come from the liability side, but with deposits declining throughout the industry, this could be happening organically at any given institution. Relative to the first two options, however, there is relatively low pound-for-pound value. Though it depends on a variety of variables, a depository with a tangible ratio at 5% could reduce assets by 10% and see approximately 55 bps of improvement in the tangible ratio; with an AFS book at 25% of assets, that improvement would be offset by only a 41 bps move in rates at a credit union or a 55 bps move at a bank.

Though this strategy doesn’t mitigate the possibility of declining tangible ratios, it does help to mitigate the risk of potentially worsening haircuts on loans, especially in an economic environment and real estate market that may be deteriorating. Regardless of credit status category, members need to list and deliver securities to borrow against them, but preserving, or even expanding, borrowing capacity in a time of falling liquidity could be beneficial.

Recent market conditions have created challenges and opportunities for FHLBank Boston members. Our Financial Strategies group has developed a suite of analytical tools designed to help you. For more details about this tool or managing tangible capital, please contact me at 617-292-9616 or sean.carraher@fhlbboston.com or reach out to your relationship manager for more details on this tool or other matters.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.