The One Good Legacy of the Crisis for Banks

Bankers are eager to put the last few years behind them, but there is at least one souvenir they will cherish: a tax benefit from all those losses.

Now that more banks are producing steady profits, the time has come for them to realize the value of those so-called deferred tax assets. Investors and analysts want to know when the stronger banks plan to deploy the tax benefits, which were useless until profits returned.

Losses sustained in the first part of the downturn created the benefits. Banks could move them off the books through an accounting maneuver called a valuation allowance. When returned, they act like tax credits and can pad earnings, too.

Leading the pack is Pinnacle Financial Partners in Nashville. The $4.8 billion-asset company has been profitable since the third quarter of 2010, and it took advantage of its deferred tax asset in the third quarter of this year. The benefit covered its quarterly tax bill and boosted earnings by $17 million, to $24.5 million in the quarter. That was nearly fives times greater than the profits in the previous quarter.

Deferred tax benefits can also improve tangible common equity. Pinnacle's tangible common equity ratio was 8.2% at the end of the quarter, up more than 50 basis points from the previous quarter.

Under accounting rules, tax deferred assets may not be used until a bank can reasonably demonstrate that it can stay in the black once it gets back there. For that reason, their use is a welcome sign of stability, boost to earnings and way to increase tangible common equity without diluting shareholders. Private-equity partners that recapitalized banks are also interested, as several structured their deals as to not disrupt the future reversal.

Pinnacle executives say there is no secret formula, just solid performance over time. "For us, it came down to sustained profitability. Our credit metrics improved and we were also able to anticipate credit costs," says Harold Carpenter, chief financial officer of Pinnacle. Company officials and auditors "have to be on board."

Analysts and auditors believe that Pinnacle might be the first community bank to make full use of its benefit. To that end, Carpenter said, it was like charting new territory.

"There was a lot of discussion as to how to do it," Carpenter said. "There is not a lot of guidance on reversals and what needs to happen for it to occur."

Daniel Trigg, a partner with McGladrey & Pullen LLP, says that he is looking for at least three quarters, if not a full year of earnings, before he would consider recommending a reversal.

"You have to overcome the negative evidence. If you've lost money for the last three years why would I believe you can now generate taxable income?" Trigg says. "After you have a history of profitability, I would then say you have a case for your ability to generate income."

Trigg says he is also looking for core profitability, not quarters inflated by the sale of securities.

Chuck Laetsch, a partner in the federal tax group at Crowe Horwath LLP, says the industry is still deciding "how much evidence is enough evidence."

Additionally, Laetsch says that he expects several banks to book partial reversals, bringing back only the amount they can use to offset current taxes.

"I think very few banks will have a full reversal," Laetsch says. "Most don't need that, it is very aggressive and harder to do."

In the third quarter, Preferred Bank in Los Angeles reversed $4.5 million of its valuation allowance. It still has another $18 million to $20 million to recover, and officials said during a conference call with investors that it would do that over time as it works its way down to zero.

Joseph Fenech, an analyst at Sandler O'Neill & Partners LP, published a research note last week that said Pinnacle's reversal would bode well for several community banks across the country as they look to bring the deferred tax asset back onto the balance sheet.

"Pinnacle gives us a little road map of what to expect," Fenech said. "This matters because it is hidden value embedded in the balance sheet. When you factor it back in, it improves the view of the company."