European Banks Are Cooking Up a Nice Regulatory Arbitrage
I don't have much to add to this International Financing Review article titled "Banks target DTAs to boost capital," but it brought tears of joy to my eye, and I'll pass it along because at least some of my readers share at least some of my aesthetic sensibilities. That's probably a minority, even of my readers. Honestly this is some kinky stuff. But if you like this sort of thing, this is the sort of thing you'll like.
The story is that regulators require banks to have a certain amount of capital. Capital is -- and everything I say here is very approximate and schematic, just go with it -- but the way you figure out capital is that you add up all the bank's assets, then you subtract its liabilities, and what's left over is capital. And regulators want you to have more of that. One way to get more of that is to go sell stock, but that is expensive. Banks would prefer to get more capital using magic, because magic tends to be cheap.
Now "add up the assets and subtract the liabilities" is roughly how you calculate capital, but it's not quite that simple. In particular, some assets don't count. Most of the obvious assets -- stocks, bonds, buildings, whatever -- count, but various intangible things don't count. For instance, deferred tax assets don't count. DTAs are the present value of future tax deductions due to past losses. So if you lost a lot of money in the past, you get to carry forward those losses to reduce your taxes in the future, and -- for accounting purposes -- you get to treat that reduction as an asset now.
Unlike the accounting rules, capital rules don't treat DTAs as an asset for calculating capital. Not just because they sound weird, but because there's no guarantee that the DTA will actually provide economic benefits. If the bank stops being profitable in the future, there will be no taxable profits to be reduced by the past losses, so the DTAs will end up worthless. And since capital regulation is designed to keep banks sound even when they run into rough patches, counting DTAs in capital computations would actually be counterproductive. These are exactly the sorts of assets that won't protect you if things go wrong.
Fine, all very sensible. But there you are, you're a bank, you have lots of past losses, they create lots of accounting assets, and you stare at these multi-billion-euro piles of assets and you get just so angry that you can't use them in your capital calculation. It doesn't seem fair. Surely there's a way to make these assets count?
Of course there is! The way is to sell them! You have an asset, it's worth billions of euros, it doesn't count for capital purposes, but if you sell it for billions of euros, then you'll have billions of euros, and cash does count for the purposes of calculating capital. So you should sell your DTAs.
But just because capital regulators don't let you count DTAs in computing your capital, and tax regulators don't let you sell your DTAs in the open market, doesn't mean you can't basically do both of those things. You just issue notes linked to the DTAs. That's what some European banks are working on:
While banks are tinkering with various structures in bond, swap and insurance formats, the concept in each case is comparable to a structured note. An investor fully collateralises a chunk of a bank's DTAs - most likely in the region of US$500m - for a pre-agreed length of time, usually three to seven years.
The principal in the structure is transformed into more senior liabilities as the bank rakes in profits and uses up its DTAs. If the profits do not materialise, the investor is on the hook to absorb these capital losses. In return, the investor receives a coupon, which is either fixed at the outset or varies as the DTAs are consumed.
So, economically, the investor is in the position of having bought the DTAs. If the bank is profitable, the investor receives the bank's tax deductions. If it's not, the investor gets nothing. The bank gets the present value of the DTAs -- discounted at some reasonable rate, IFR says it's "likely to be benchmarked against a firm's junior debt plus a premium to reflect the illiquidity and complexity of the structure" -- up front, in cash, as an asset, which should increase its capital.
Unless of course it has to book the DTA-linked note as a liability, which would offset that asset for capital calculations and make this whole exercise pointless. The banks think they shouldn't have to: These notes are equity! They only pay off if the DTAs do! And that ... I mean, that seems exactly right to me. This really does seem like a way to increase banks' capital -- like, for real, by selling equity-ish securities to outside investors for cash -- at a slightly lower cost to the bank than actually raising common equity. It really does transform DTAs, which are not there when banks need them, into cash, which is there when it's needed.
I have absolutely no problem with this is what I'm saying, but I guess that right there might be enough to make you suspicious.
What kind of financial innovation is this? It is emphatically not the kind where banks come up with new ways to make their clients' lives better and less risky.
Nor does it really seem to be the bad kind of regulatory arbitrage, where banks just get around rules that are intended to make them safe, by being less safe.
It's just the relatively harmless kind of regulatory arbitrage: The regulations have some imperfections, some asymmetries, some things that they really should allow but don't, some rough patches that need smoothing out. So you devote time and effort and billion-euro trades to smoothing them out. It's not evil, per se, or dangerous. It might be a little wasteful. But all beauty is in a sense wasteful, and this right here is some lovely stuff.
(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)
Otherwise every failed company would just sell its tax losses to successful companies, in a delightful arbitrage. NOL poison pills, which prevent companies with big deferred tax assets from changing control, are related to this: The IRS doesn't want companies with big loss carryforwards to sell those losses, even in a change of control.
Paid in the currency of the bank's senior debt but, again, just go with it.
From reading the IFR article, I mean. There are probably weird corner cases buried deep in the documentation where it doesn't quite work like that; the trick is to find them. The other trick is: Do those corner cases go against the banks (in which case, this stuff shouldn't be good capital), or against the investors (in which case, hahaha, nice work banks). Anyway, here's a tax partner at Ernst & Young:
"Even in Europe I think there's a great deal of scepticism among the accounting firms that these DTA-linked notes could work," he said. "An accountant would say you've raised cash and issued debt, that's how you should record it, not as proceeds from the sale of a DTA."
Still, others are confident of winning regulators over by structuring trades that involve a real economic risk transfer.
A trickier question is whether it works like a sale of the DTAs for tax purposes. If it does then it seems like a bit of a tax shelter? The question is whether someone gets to take the deductions even if the bank is unprofitable. If the bank is profitable, it takes the deductions. If the bank is not profitable ... the investor has a loss? Which seems deductible if the investor is a taxable investor? Hmm. Hmm.
You can tell because the banks are the "clients," as it were. They're paying the spread. On the other hand, the buyers -- the potential buyers, these things are very hypothetical at this stage, but they seem to be the sorts of squonky hedge funds that do capital relief trades -- are probably making out very nicely on the trade, so it's customer service in that sense.
Nor, probably, is it innovation for the purpose of confusion. Banks sell some weird stuff to widows and orphans, but probably not this weird stuff. If you buy this stuff, you know what you're getting into.
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