Leverage for Banks Seen Impeded by Fed Rules on Basel III: Taxes

New rules from the Federal Reserve will significantly alter how banks account for taxes on some assets, especially at large institutions.

New standards change the math behind whether taxes can be deferred on some items when banks compute how much capital they have. If deferrals are removed, the result can be a significant reduction in the size of a bank’s balance sheet -- possibly making it look less stable, Bloomberg BNA reported.

The rules, which will force companies to perform a far more complex calculation of deferred tax assets and liabilities, are part of the heightened capital standards for U.S. banks known as Basel III -- rules drawn up by global regulators intended to make the financial system safer after the collapse of Lehman Brothers Holdings Inc. They are meant to help community lenders, while taking a stricter line with large banks.

“The new focus of tax planning will be to effectively manage a bank’s deferred tax position to enhance regulatory capital,” said Liz L’Hommedieu, KPMG LLP’s tax managing director for its Washington National Tax practice.

The new regime goes into effect Jan. 1 for the largest banks -- those with assets greater than $250 billion or with more than $10 billion in foreign exposures, such as Bank of America Corp., JPMorgan Chase & Co. or Wells Fargo & Co. Smaller banks have until 2015.

The idea behind the rules, issued last month, is to provide more uniformity in the 27 countries of the Basel Committee on Banking Supervision -- so banks in France, Hong Kong or the U.S. can run comparable analyses of capital profiles, said John Taylor, partner with the Financial Services Tax Practice at EY.

New Limits

The rules limit how and when deferred tax assets must be subtracted from equity to determine a bank’s capital, which is used to assess the financial health of a bank, EY said in a July report. Banks must meet minimum capital levels and have new minimum ratios of capital to risk-weighted assets.

A complicating factor is that the calculation must now be done on a jurisdiction-by-jurisdiction basis, both state and foreign. In other words, unlike the current rules, banks won’t be able to offset liabilities in one jurisdiction against assets in another in computing the limits, Taylor said.

That can be a big deal. The extent to which the deffered tax assets are subtracted from capital reduces the amount of leverage a bank can have, Taylor said. Higher leverage can often mean more potential for profits, but it also exposes the Federal Deposit Insurance Corp. to a greater risk “in the event things go sour,” Taylor said.

If deferred tax assets are cut from the math in a bank’s capital, it can reduce the size of a bank’s balance sheet by about 14 times the amount of disallowed assets, Taylor said.

Good Conversions

Banks will need to assess their positions and review accounting methods for the deferred tax assets, known as DTAs, to gain the best tax position, L’Hommedieu said during a KPMG webinar on the final rules.

“Opportunities and areas of exploration may include converting ‘bad’ DTAs into ‘good’ DTAs by accelerating income -- deferring expenses or accelerating deductions,” she said.

The rules probably will result in more footnote disclosures in annual reports with the Securities and Exchange Commission and in more detailed disclosure in quarterly earnings reports “where a reader can see precisely why a financial institution’s capital is what it is,” Taylor said.

This may be an important development because capital drives a lot of a bank’s behavior, Taylor said. If a bank appears to be hovering near its minimum level of capital, it may not be able to grow, he said.

“The market will put a lot of emphasis on those metrics,” Taylor said.

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