News that the European Commission is considering whether certain EU members’ treatment of bank deferred tax assets (DTAs) constitutes illegal state aid has brought this festering issue to the fore. The four culprits are Spain, Italy, Portugal and Greece, whose banks have all relied heavily on these assets to build up their capital buffers.
Deferred tax assets are discounts on future tax bills accumulated in times of loss. They count as capital but only work in practice if the bank becomes profitable. According to SNL Financial, by the end of 2013 eurozone banks had €105.6 billion of DTAs on their books, accounting for 40% of bank CET1 in Greece, more than 20% in Portugal and 15% in Spain.
“DTAs are basically an option – one that can remain out of the money for a long time if banks aren’t profitable,” says Alberto Gallo, head of European macro credit research at Royal Bank of Scotland. “The trouble is that the most struggling banks are the ones that have accumulated the most DTA capital over the years.”
European competition commissioner Margrethe Vestager has written to each of the four member states requesting further information on bank reliance on DTAs to meet capital requirements. Under Basel III, increasing discounts are imposed on these assets until they are phased out altogether. When CRD IV was introduced in 2013 it was stated that 20% would be deducted in 2014, 40% in 2015, 60% in 2016 and 80% in 2017. Full deduction will be required from 2018 onwards.
The four targeted countries now under scrutiny by the regulator got around this problem by introducing legislative changes that enabled DTAs to be transformed into a different instrument – deferred tax credits (DTCs). These are not contingent on future profits and can be counted as capital regardless of whether the bank makes a profit or a loss.
“DTAs have been around for a long time,” says the head of FIG DCM at a bank in London. “They were meant to be phased out. But as long as they are covered by a government guarantee then they are explicitly allowed under the CRD IV directive.”
Article 39.2 of CRD IV says deferred tax assets are still acceptable as capital if they are transformed on a mandatory and automatic basis into a tax credit and, in specific cases, replaced with a direct claim on the government.
This loophole is now firmly in the new single supervisor’s sights. Danièle Nouy, chair of the ECB’s single supervisory mechanism board, says there are too many national options in the definition of capital and that this needs to be addressed.
The investigation is in its early stages but it could have serious consequences for some banks. Banco Sabadell, for example, has €6.14 billion of DTAs, which account for 70.6% of its CET1. Its acquisition of TSB in the UK is likely to draw attention to its capital position.
But Justin Bisseker, banking analyst at Schroders in London, argues that in scrapping DTA eligibility altogether the regulators are being unfairly harsh. “With TLAC [total loss-absorbing capacity] and MREL [minimum requirement for own funds and eligible liabilities] you will have so much loss-absorbing capital in the banking system it would be very draconian to say that DTAs have no value whatsoever,” he says. “Regulators may not like the guaranteed elements of DTAs, but once TLAC is in place these assets have value at the point of resolution.” He maintains that the treatment of these assets should reflect the different tax environments in which banks across Europe operate.
Bisseker says DTA guarantees were needed in part because of material differences in tax law across Europe. “For example, in countries such as France and the UK banks can carry back losses to previous periods whereas in Spain this is not possible,” he says. “Meanwhile, Italian bank DTAs tend to be large because of limitations on the tax deductibility of credit losses meaning that banks have a genuine claim on the government. The basic problem is that there is no fiscal harmony in Europe.”
However, with Nouy strongly focused on the issue of capital quality, the extinction of DTCs for capital purposes looks inevitable. The question is what form it takes. “They may keep DTCs at the bank level and punish banks in other ways for having essentially received state aid,” muses the FIG banker.
Given the precarious financial position of many of the peripheral banks involved the regulators will need to tread very carefully. Such a move will lay bare the vulnerability of these institutions. While this may trigger some much-needed consolidation it will not be without a great deal of pain beforehand.
“If there is a regulatory change that creates a black hole in the banking sector it will result in a credit crunch, not consolidation,” says Schroders’ Bisseker.