Does anyone remember Deferred Tax Assets?

Banks like Citi used to be (and in fact, still are) stuffed with them. In fact the assets have become a point of contention over the past year and a half, as regulators, analysts and investors debate the quality of banks’ capital. Tax assets can be included in banks’ Tier 1 regulatory capital, under certain circumstances, and hence we eventually saw a shift in emphasis towards the ‘purer’ tangible common equity, which strips out stuff like DTAs.

In any case, DTA’s allow companies to reduce the amount of tax that they’ll need to pay in a later tax period. Reuters puts it well:

Deferred tax assets arise because companies keep two sets of books: one for taxes and one for reporting to investors. Income in these two books may be different at different times.

If a company has a loss on the income it reports to investors, but cannot record the loss for tax purposes until the future, it records a deferred tax asset, which reflects the future cash flow from paying lower taxes.

But if a company is unlikely to generate enough taxable income in the future, it must essentially write down the deferred tax asset, which it does by creating a “valuation allowance” on its balance sheet. That valuation allowance cuts into income reported to investors and can hit a portion of a bank’s regulatory capital, as well.

In fact, according to Fitch, DTAs grew in dollar terms by nearly 300 per cent over the 12-months to June 30 2009 and now account for 10.7 per cent of equity for US banks, on average. And while the rating agency doesn’t think the rise in DTAs will impact the banks’ ratings, they do see an imminent impairment risk:

The uncertainty surrounding individual companies’ operating performance coupled with the higher level of DTAs, increases the risk that certain banks will need to write down their DTAs and/or have their DTAs disallowed from regulatory capital. Fitch’s analysis indicates that DTA impairments, in and of themselves, are currently unlikely to result in widespread rating actions.

The risk to DTA impairments will become greater before it subsides, and more banks will become vulnerable to write-downs,’ said Julie Solar, Director in Fitch’s Financial Institutions Group, ‘but the risk to profitability and capital diminution is modest in aggregate at this point in time.’

And the story looks much the same in Europe.

To wit, JP Morgan analysts Sarah Deans and Dane Mott have been looking at DTAs for Europe’s banks, and have come up with the following numbers:

They note that:

Deferred tax assets (DTAs) have become significant as a percentage of shareholders’ equity for some banks. Investors should be aware of the potential exposure to tax write-downs, particularly given the possible impact on Tier 1 capital measures, although we differentiate between different sources of deferred tax assets. Tax assets, particularly those arising from tax losses, may have to be written down if future profitability is less than expected, and as such may indicate poorquality capital.

And that’s not even to mention the potential regulatory threat.

RBS, for instance, has agreed to not use £4.6bn of its DTAs as part of the fundraising scheme agreed with the UK Treasury on Wednesday. The US already has caps on the amount of DTAs that can count in Tier 1 regulatory capital but that could well become more onerous. The American Bankers Association, we should note, together with The Clearing House, is currently lobbying for US regulators to “revisit” the limits on DTAs in banks’ regulatory capital. There’s also the possibility that regulators could simply turn a blind eye in the sort of regulatory forbearance strategy pursued by Japan during its banking crisis.

In the meantime though, the question really is whether banks can earn enough, or convince regulators that they can earn enough, to justify their DTAs and thereby avoid impairments.

Citi, incidentally, has got $38bn worth of DTAs — $13bn of which counted towards its Tier 1 capital — according to third-quarter 2009 results.

According to the bank:

Another Citigroup official said the company is confident in its ability to earn enough over the next 20 years to warrant the current size of the DTA. This official said Citigroup’s outside auditor, KPMG, has signed off on the company’s third-quarter DTA.

Whatever you say.

Related links:
Citi talks to Treasury; analysts debate tax assets – Wall Street Journal
Estimates of losses on banks’ tax assets rattle investors – Dow Jones
The rise of deferred tax assets in Japan: The case of the major Japanese banks – University of Chicago paper (via SSRN)
Fannie Mae to reduce value of deferred tax assets – Bloomberg

Copyright The Financial Times Limited 2024. All rights reserved.
Reuse this content (opens in new window) CommentsJump to comments section

Follow the topics in this article

Comments

Comments have not been enabled for this article.