Over the last weeks, the issue of bank Deferred Tax Assets (DTAs) came up again. What does not really help ending this story is the confusion on the subject of DTAs.
Let me make a stab in trying to end the DTA confusion.
Here are some snippets that from various news sources that I gathered. They are invariably against using DTAs to bolster bank capital.
- “This also applies to the treatment of Deferred tax assets (DTA) as equity capital.” – from the German non-paper that wants to end the toxic link between governments and banks.
- “There are different areas: for example, recognition of deferred tax assets … which naturally has an impact on capital” from an interview with ECB’s Ignazio Angeloni on harmonising bank capital in Europe.
- “The European Commission and European Central Bank have frowned upon the practice [of using tax benefits as capital] as they draw up rules to prevent a repeat of the eurozone financial crisis.” from the Financial Times.
- ‘‘As regards the remaining guaranteed DTAs, the commission continues to assess the law in place” to make sure there is a “level playing field” in EU banking markets, Cardoso said.
The battue on bank DTAs, however, does not really make sense, in fact: the CRR creates the desired level playing field as we speak.
Patience is a virtue … ? It is important to realise that DTA’s are an accrual, a tool to account for differences in the timing of the receipt of a revenue and its underlying cash collection. In Italy, Spain, Greece, and Portugal, the tax rules are such that they create a significant timing difference: the tax credit that originates from a loss this year may take many years to collect. In other words, the tax rules impose patience on the receiving bank. They have to unwind their DTAs over a long period.
Prudential folks respond to the imposed patience by highlighting the uncertainty of the future tax credits (the bank may go out of business), and use this uncertainty as the reason to deduct DTA’s from capital.
The DTA deduction therefore punishes a bank in two ways: by forcing the bank to be patient, and because of the imposed patience, by deducting DTAs from capital.
Other countries, however, benefit from instant gratification. Compare this to countries – France, Germany, and recently Italy – that allow banks to deduct losses immediately from profit. These banks receive an instant credit from the tax authorities. No questions asked, even though this too establishes a link between banks and governments.
The CRR gives them a break. If you now go back to the CRR and read the requirements* that allow a bank to turn a DTA into a receivable, then they make perfectly sense: they establish a level playing field between countries that eliminate the aforementioned uncertainty by accepting the loss deduction immediately and countries that do not give their banks such a tax break.
The CRR even applies a 100% risk weight to the deferred tax assets, which is the risk weight applied to non-investment grade exposures!**
*CRR Article 39.2. Deferred tax assets that do not rely on future profitability shall be limited to deferred tax assets arising from temporary differences, where all the following conditions are met:
|(a)||they are automatically and mandatorily replaced without delay with a tax credit in the event that the institution reports a loss when the annual financial statements of the institution are formally approved, or in the event of liquidation or insolvency of the institution;|
|(b)||an institution shall be able under the applicable national tax law to offset a tax credit referred to in point (a) against any tax liability of the institution or any other undertaking included in the same consolidation as the institution for tax purposes under that law or any other undertaking subject to the supervision on a consolidated basis in accordance with Chapter 2 of Title II of Part One;|
|(c)||where the amount of tax credits referred to in point (b) exceeds the tax liabilities referred to in that point, any such excess is replaced without delay with a direct claim on the central government of the Member State in which the institution is incorporated.|
Institutions shall apply a risk weight of 100 % to deferred tax assets where the conditions laid down in points (a), (b) and c) are met.
**CRR Article 114
Exposures to central governments or central banks
- Exposures to central governments and central banks shall be assigned a 100 % risk weight, unless the treatments set out in paragraphs 2 to 7 apply.
- Exposures to central governments and central banks for which a credit assessment by a nominated ECAI is available shall be assigned a risk weight according to Table 1 which corresponds to the credit assessment of the ECAI in accordance with Article 136.
|Credit quality step||1||2||3||4||5||6|
|Risk weight||0 %||20 %||50 %||100 %||100 %||150 %|
- Exposures to the ECB shall be assigned a 0 % risk weight.
- Exposures to Member States’ central governments, and central banks denominated and funded in the domestic currency of that central government and central bank shall be assigned a risk weight of 0 %.
- Until 31 December 2017, the same risk weight shall be assigned in relation to exposures to the central governments or central banks of Member States denominated and funded in the domestic currency of any Member State as would be applied to such exposures denominated and funded in their domestic currency.
- For exposures indicated in paragraph 5:
|(a)||in 2018 the calculated risk weighted exposure amounts shall be 20 % of the risk weight assigned to these exposures in accordance with Article 114(2);|
|(b)||in 2019 the calculated risk weighted exposure amounts shall be 50 % of the risk weight assigned to these exposures in accordance with Article 114(2);|
|(c)||in 2020 and onwards the calculated risk weighted exposure amounts shall be 100 % of the risk weight assigned to these exposures in accordance with Article 114(2).|
- When the competent authorities of a third country which apply supervisory and regulatory arrangements at least equivalent to those applied in the Union assign a risk weight which is lower than that indicated in paragraphs 1 to 2 to exposures to their central government and central bank denominated and funded in the domestic currency, institutions may risk weight such exposures in the same manner.
For the purposes of this paragraph, the Commission may adopt, by way of implementing acts, and subject to the examination procedure referred to in Article 464(2), a decision as to whether a third country applies supervisory and regulatory arrangements at least equivalent to those applied in the Union. In the absence of such a decision, until 1 January 2015, institutions may continue to apply the treatment set out in this paragraph to the exposures to the central government or central bank of the third country where the relevant competent authorities had approved the third country as eligible for that treatment before 1 January 2014.
5 thoughts on “In defence of bank DTAs”
I thought the main issue arises from the fact that some countries allowed their banks to convert DTAs in deferred tax credits, and that this DTCs are not deducted from tier 1.
Consider the case when the bank is so loss-making that even with no immediate deductibility of loan losses it does not have to pay taxes; the DTA is no longer the mere recognition of a tax “overpayment” (meaning the banks pays taxes on taxable income X in year one while the taxable income X will disappear in year 5, reducing tax paid in year 5). Then if this DTA, by law, can be converted into a tax credit or paid in cash upon resolution or liquidation, then the law creates a kind of “negative tax” or “subside for losses”, which makes the State liable for losses incurred by private companies. And such example is not fantasy for some individual banks. Comparing the actual amounts of tax paid by banks and the amount of accumulated DTAs helps to differentiate mere tax overpayments from subsidies to zombie banks.
How does this differ from recognition of the loss in the current year for tax purposes?
Problem is not DTAs per se: auditors have to carry out impairment tests which means if the bank is not profitable, it can’t book unlimited DTAs (in that case DTA is only the expected reduction in future taxes); and if the bank is liquidated, then the value of those assets is zero which explains why they are gradually deducted from capital for regulatory purpose.
Problem arises when by law those DTAs become a claim on the State upon resolution or liquidation. Imagine a bank which in year 1 books losses that far exceed the taxable income:
taxable income = 100
tax = -25
impairments = -1000
DTAs = +250
if the situation keeps deteriorating in year 2 and the bank is put in bankruptcy proceedings, then the DTAs are converted into a claim toward the State, which will pay 250 to compensate the creditors of the banks. Since those DTAs become loss absorbing in case of liquidation, they are not deducted from regulatory capital. Since they become a hard claim toward the state, the auditors no longer carry out impairment tests (even if bank not profitable, ultimately it is a sovereign exposure).
Therefore they constitute a material advantage for those bank which are not viable (as otherwise they would have to book impairments on those DTAs and would need to raise capital). But in addition it is a huge risk for the State (and we are talking about Southern European countries) and also a material impediment to resolution/liquidation (in practice the State has to absorb losses for no consideration before any other investor).
True, DTAs do not grant advantages to profitable banks; but when legislation allows those DTAs to be converted into hard claims upon resolution or liquidation, they artificially keep alive a few zombie banks and reinforce the bank-sovereign nexus.
I get that, but how does this differ from directly deduction from profit? Also not sure why auditors would not impair a receivable.
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