Banks with large loan loss provisions or large net operating loss carryforwards should be considering the amount of deferred tax asset that can be recorded. Generally accepted accounting principles allow for a deferred tax asset to be recorded even if some of the reversal of the asset is expected to come from future taxable income, so long as the bank can demonstrate a good probability of generating future taxable income. Deferred tax assets that can be realized through carrybacks to taxes paid on income earned in prior periods and from the reversal of existing taxable temporary differences generally will not be limited.

However, for regulatory capital purposes, deferred tax assets that are dependent on future taxable income are limited to the lesser of: (1) the amount of deferred tax assets the bank expects to realize within one year of the calendar quarter-end date, based on its projected future taxable income for that year or (2) 10% of the amount of the bank’s Tier 1 capital. This is becoming an issue for banks due to the size of their deferred tax assets.

Liquidity Risk Management

Liquidity risk management has become a hot topic during regulatory examinations. Regulators are demanding that some banks perform much more intensive liquidity contingency planning, including using pro forma cash flows and hypothetical analysis for “shocking” the bank’s liquidity under various what-if scenarios, including the bank’s inability to access brokered deposits, planning for large withdrawals of significant deposits under various timelines and other items. This seems to be more of an issue for those banks experiencing a drop in their regulatory ratings or experiencing inability to manage complex liquidity exposure.

Other-Than-Temporary-Impairment (OTTI) of Investments

OTTI has received much press in light of government takeover of Fannie Mae and Freddie Mac. Accounting rules say that when a fair value of an investment security under FAS 115 is less than amortized cost, the bank must consider whether an OTTI charge should be taken against income or whether it is OK to continue to show the unrealized loss as a direct charge to equity.

For those holding Fannie Mae or Freddie Mac common or preferred stocks, it would seem to be difficult to come to any conclusion other than the stocks are other-than-temporarily impaired, which means a charge to income.

However, there are other securities that need to be at least considered for OTTI, including investments in trust-preferred security issues, auction rate securities and mutual funds backed by mortgages, to name a few. Banks should be taking a look at their securities’ fair values and challenging whether or not OTTI should be considered. Banks will have to carefully consider whether or not a related deferred tax asset can be recorded or not, since the loss is considered a capital loss and banks typically don’t generate a lot of capital gains. Consult with your tax advisor for more information.